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

When building a rating transition matrix from historical data, an analyst finds that no obligor rated AAA defaulted directly within a one-year period, so the matrix shows 0% one-year default for AAA. What is the best interpretation?

A zero default entry for AAA most likely reflects a limited sample, not true impossibility. The actual one-year default probability is very small but positive, so analysts may use smoothing or longer histories to estimate it.

  1. AAAA obligors can never default, so default risk is exactly zero
  2. BThe zero is likely a sample artifact, so the true default probability is small but positiveCorrect
  3. CThe data must be wrong because every rating class must show defaults
  4. DZero default implies AAA obligors will never be downgraded

Explanation

With few defaults observed in very high rated classes, a zero estimate reflects limited data rather than impossibility. Default risk is small but positive, and smoothing or other estimation methods may be used.

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