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

An analyst compares a corporate bond rated BBB with a structured-finance tranche also rated BBB. Which statement best reflects a known limitation of treating the two ratings as equivalent?

A BBB structured tranche is not equivalent to a BBB corporate bond. The tranche depends heavily on systematic, correlated defaults, so its rating can drop several notches in a downturn, whereas corporate ratings migrate less severely.

  1. AThe tranche rating is typically far more sensitive to systematic risk and can migrate by several notches in a downturn, whereas corporate ratings are less volatileCorrect
  2. BThe tranche necessarily has a lower default probability because it is diversified across many assets
  3. CCorporate ratings are always more volatile than structured-finance ratings because of idiosyncratic risk
  4. DThe two ratings are identical in loss distribution by construction

Explanation

Structured tranches are concentrated on systematic factors (correlated defaults), so their ratings can fall many notches in a crisis, unlike similarly rated corporates. Diversification of the pool does not remove correlation risk, so equating them is misleading.

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