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FRM Part I · FRM Exam Part I · Measuring Credit Risk

An analyst estimates a transition matrix using the cohort approach and finds that the estimated probability of default for a highly rated (AAA) obligor over one year is zero. Which of the following is the most appropriate interpretation?

A zero estimated default probability for AAA most likely reflects limited data: few or no AAA defaults were observed in the sample. It does not prove the true risk is zero, and approaches such as the duration or hazard-rate method can produce small positive estimates.

  1. AAAA obligors can never default, so the zero is a reliable estimate
  2. BThe sample probably contained few or no AAA defaults, so zero reflects limited data rather than zero riskCorrect
  3. CThe matrix must contain an error because default probabilities cannot be zero in any rating
  4. DThe zero shows that AAA ratings are point-in-time rather than through-the-cycle

Explanation

Historical frequencies for high-quality grades are based on very few or no observed defaults, so a zero estimate reflects sample limitations rather than true absence of risk. Alternatives such as the duration (hazard) approach can give nonzero estimates.

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