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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

An analyst estimates transition probabilities using the cohort approach versus the duration (hazard rate) approach. Which statement correctly describes a difference?

The cohort approach uses only start and end of period ratings, ignoring intra-year moves, while the duration approach uses every rating change and its timing. This lets the duration method estimate rare transitions and arbitrary horizons more effectively.

  1. AThe cohort approach uses only year-start and year-end ratings and ignores intra-year migrations, while the duration approach uses all rating changes and timing, so it can estimate probabilities of rare transitions betterCorrect
  2. BThe cohort approach uses continuous-time rating histories, while the duration approach uses only annual snapshots
  3. CThe duration approach cannot produce estimates for shorter horizons than one year
  4. DThe cohort approach always gives non-zero probabilities for every possible transition

Explanation

The cohort approach counts obligors at the start and end of each period, ignoring intra-period changes and time spent in each rating. The duration (intensity) approach uses the exact timing of every migration, so it can give non-zero estimates for rare transitions that never appeared in annual snapshots and supports any horizon.

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