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FRM Part II · FRM Exam Part II · Credit Value at Risk

In CreditMetrics, the equity-return (asset-return) correlation between two obligors is used to derive joint migration probabilities. How are these correlations typically obtained, and why?

CreditMetrics estimates asset-return correlations from a factor model of equity returns on country and industry indices, since firms' asset values cannot be observed and equity returns serve as a proxy. These correlations combine with the marginal transition probabilities to give joint migration probabilities.

  1. AFrom the correlation of the bonds' historical credit spreads, because spreads are directly observable
  2. BFrom a multi-factor model of equity returns on country and industry indices, because obligor asset values are unobservable and equity returns proxy for themCorrect
  3. CFrom the correlation of the obligors' ratings changes, because ratings are discrete
  4. DFrom the transition matrix itself, because it contains joint information

Explanation

CreditMetrics uses a Merton-style link between asset value and rating thresholds. Since asset values are not observed, equity returns are used as proxies and decomposed with industry and country factors to obtain pairwise correlations. The transition matrix gives only marginal probabilities, not joint ones.

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