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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

Which of the following best describes the cliff effect associated with reliance on external ratings?

The cliff effect is when a downgrade through a key threshold, such as below investment grade, triggers rating-based rules, forced selling, or collateral calls. These actions amplify market stress and can in turn lead to further downgrades.

  1. AA downgrade below a threshold such as investment grade can trigger forced selling or collateral calls, amplifying market stressCorrect
  2. BRatings of all issuers rise simultaneously when interest rates fall
  3. CAgencies withdraw ratings when issuers pay off debt, producing sudden gaps in data
  4. DRatings are updated only once every ten years, causing abrupt revisions

Explanation

Rules in regulation, mandates and contracts keyed to rating thresholds cause mechanical selling or additional collateral demands upon a downgrade, which worsens the decline and can feed further downgrades. The other options describe unrelated phenomena.

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