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IAI Actuarial Core Principles · Economic Modelling · Simple models for credit risk

In a Markov chain model of credit ratings, which statement best describes the Markov property as applied to a bond issuer's rating?

The Markov property means the chance of moving to any future rating depends only on the issuer's current rating. How the issuer arrived at that rating, such as a past downgrade, carries no extra predictive information in the model.

  1. AThe probability of moving to a future rating depends only on the current rating, not on how the issuer reached itCorrect
  2. BThe probability of moving to a future rating depends on the full history of past ratings
  3. CRatings can only move one notch per period
  4. DDefault is not an absorbing state
  5. The transition probabilities must change every period

Explanation

The Markov property says the future depends on the present state alone. Past rating history adds no information once the current rating is known. The history-dependent option describes a non-Markov model, which is the opposite of the property.

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