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

After a sovereign downgrade, many institutional investors are forced to sell the bonds because their mandates and regulations restrict holdings to specified rating grades. Which limitation of external ratings does this illustrate most clearly, and what is its effect?

This illustrates cliff effects from hard-wired rating thresholds in regulations and mandates. A downgrade across a threshold forces simultaneous selling, which amplifies price declines and makes the financial system more procyclical, increasing rather than reducing volatility.

  1. ARating stickiness, which delays selling and reduces volatility
  2. BRating momentum, which makes downgrades impossible to predict
  3. CCliff effects from rating-based rules, which can amplify price declines and procyclicalityCorrect
  4. DRating inflation, which raises prices after a downgrade

Explanation

When regulation and mandates hard-wire rating thresholds, a downgrade across a threshold triggers forced selling, adding to price falls and procyclicality. This is the cliff effect. Stickiness and inflation do not describe forced rule-based selling, and the effect is amplification, not dampening.

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