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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

A risk manager notes that agency credit ratings of corporate bonds tend to change slowly, often after market prices and credit spreads have already moved. Which limitation of external ratings does this observation best describe?

The observation describes ratings lagging the market. Agencies use a through-the-cycle approach that smooths temporary fluctuations, so rating changes come after credit spreads and prices have already moved. This makes ratings stable but slow to signal deterioration.

  1. ARatings are through-the-cycle and therefore lag market-based signals of credit deteriorationCorrect
  2. BRatings are point-in-time and therefore overreact to short-term market volatility
  3. CRatings measure only loss given default and ignore default probability
  4. DRatings are issued only for sovereign borrowers and so omit corporate information

Explanation

Agencies aim to rate through the cycle and avoid frequent reversals, so ratings adjust slowly and lag credit spreads and equity prices. Option B describes the opposite behavior. Ratings chiefly reflect default probability, not only LGD, and they cover corporates too.

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