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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

An analyst compares a bank's internal one-year default rates with agency data. Which feature is most consistent with a ratings-based transition matrix estimated by the cohort method versus the duration (hazard rate) method?

The cohort method uses only beginning-of-year and end-of-year ratings, so it ignores intra-year migrations and can assign zero probability to rare transitions. The duration or hazard rate approach uses the time spent in each rating and all moves, so it captures rare transitions better.

  1. AThe cohort method uses only year-start and year-end ratings, so it ignores intra-year migrations and can assign zero probability to rare transitionsCorrect
  2. BThe cohort method uses the exact timing of every rating change, so it captures rare transitions more accurately
  3. CThe duration method ignores the time spent in each rating and uses only year-end ratings
  4. DThe two methods always give identical matrices when the portfolio is large

Explanation

The cohort approach counts issuers at the start and end of the period, ignoring path and timing, so rare transitions may show as zero. The duration (hazard rate) approach uses time spent in each state and all migrations, thereby giving non-zero estimates for rare events. The methods generally differ.

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