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

Historical data show that the one-year default rate for BB-rated issuers is 1.0% in expansions and 3.0% in recessions. A bank uses the long-run average transition matrix to set through-the-cycle capital during a recession. What is the most likely consequence?

Capital may be understated. Transition and default probabilities depend on the business cycle, with more downgrades and defaults in recessions. A long-run average matrix blends calm and stressed periods, so in a recession it underestimates actual default frequency for BB issuers.

  1. ARecession-period defaults will tend to exceed those implied by the average matrix, so capital may be understatedCorrect
  2. BCapital will be overstated because the matrix includes expansion data
  3. CDefault rates will exactly equal the average since matrices are stationary
  4. DRating downgrades become impossible during a recession

Explanation

Transition probabilities vary with the business cycle, and downgrades and defaults cluster in recessions. An average matrix blends expansion and recession experience, so applied during a recession it underestimates the realized default and downgrade frequency. Capital based on it may therefore be too low.

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