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FRM Part II · FRM Exam Part II · Credit Risk Management

An analyst notes that in a bank's historical transition matrix, the one-year probability of a BB-rated obligor being downgraded is considerably higher during recessions than during expansions. Which conclusion is most appropriate for risk measurement?

A single average matrix can understate downgrade and default risk in a downturn, because transition probabilities depend on the business cycle. Analysts should consider cycle-conditional matrices. The evidence contradicts the time-homogeneous Markov assumption rather than supporting it.

  1. AA single average matrix may understate downgrade and default risk when used in a downturn, so cycle-conditional matrices should be consideredCorrect
  2. BThe Markov assumption is confirmed because transition probabilities are constant over time
  3. CThe matrix should be ignored because ratings carry no information about credit quality
  4. DDowngrade probabilities should be set equal to upgrade probabilities to remove bias

Explanation

Transition probabilities vary with the business cycle, so an unconditional average matrix understates downturn risk. Constant probabilities would be required for a time-homogeneous Markov assumption, which the evidence contradicts. Ratings still carry information.

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