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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

When estimating a transition matrix from historical agency data, which practice is most likely to lead to a misleading estimate of the default probability for highly rated obligors?

Short samples with few or no defaults in top rating grades give zero or very unstable estimated default probabilities, which understates risk for highly rated obligors. Treating default as absorbing and using the cohort method are standard practices and not the source of the problem.

  1. AUsing the cohort method with annual observations
  2. BApplying the matrix to a portfolio with the same rating mix as the sample
  3. CEstimating from a short sample with very few defaults in top grades, giving zero or unstable estimated default probabilitiesCorrect
  4. DTreating default as an absorbing state

Explanation

Investment-grade defaults are rare, so small samples yield zero or noisy estimates, understating tail risk. Treating default as absorbing is standard, and the cohort method is a recognised approach.

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