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

A risk manager notes that observed historical default rates for a given rating differ between the start of a recession and the end of an expansion, and that rating drift is more likely after a downgrade. Which conclusion about using a single average transition matrix is most appropriate?

A single average matrix may misstate risk because transition probabilities vary with the economic cycle and show momentum after downgrades. This breaks the time-homogeneous, memoryless Markov assumption. Default risk tends to be understated in recessions and overstated in expansions when an average matrix is applied.

  1. AIt overstates default risk in all periods because averages exceed medians
  2. BIt is a reliable guide in every period because rating agencies target stable default rates
  3. CIt may misstate risk because transitions depend on the economic cycle and prior rating changes, violating the time-homogeneous Markov assumptionCorrect
  4. DIt is unbiased because downgrade momentum cancels out cyclical variation

Explanation

A single average matrix assumes transition probabilities are constant over time and independent of history (Markov). Cyclical variation and rating momentum violate this, so average matrices can understate risk in downturns and overstate it in expansions. The other options assert unsupported stability or offsetting effects.

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