FRM Part I · FRM Exam Part I · External and Internal Credit Ratings
A risk manager reviews an annual transition matrix for a portfolio of rated bonds and wants to infer default risk from it. Which observation about using a time-homogeneous Markov matrix is most valid given empirical evidence on ratings?
The matrix may understate downgrade and default risk after a recent downgrade or in recessions. Empirical ratings show momentum and cyclical variation, which violate the time-homogeneous Markov assumption. Claims of independence, cycle stability, or industry uniformity within a rating are contradicted by the evidence.
- ARatings momentum and business-cycle dependence mean the matrix may understate downgrade and default risk following a prior downgrade or during recessionsCorrect
- BEmpirical transitions are independent of past rating changes, so the Markov assumption is confirmed
- CDefault probabilities are identical across industries within a rating, so the matrix needs no adjustment
- DMatrix estimates are stable across the economic cycle, so a recession-period matrix equals an expansion-period one
Explanation
Empirically, recently downgraded issuers are more likely to be downgraded again (momentum), and transition and default rates vary with the cycle. A single time-homogeneous matrix therefore can understate risk in downturns or after downgrades. The other options assert independence, stability, or homogeneity that evidence contradicts.
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