medium · Frm Part 2 Credit Risk
A 2-year cumulative PD is calculated using a 1st-year transition matrix M. A 'red-herring' piece of data is provided: 'The LGD for this portfolio is expected to rise from 40% to 60% in a stress scenario.' If the analyst is asked for the cumulative PD over 2 years in the stress scenario, they should:
- Increase the 1st-year PD by 50% because PD and LGD are positively correlated in stress.
- Recalculate the matrix using risk-neutral hazard rates to incorporate the LGD change.
- Ignore the LGD data, as LGD affects expected loss and capital but not the default probability itself.
- Multiply the calculated cumulative PD by 1.5 to account for the increased severity.
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