medium · FRM Part 2 Credit Risk
A quantitative credit analyst is validating a 1-year transition matrix M for a corporate loan portfolio. The model assumes the Markov property holds.
If an obligor is currently in grade B, which of the following best describes the structural implication of this property for the probability of the obligor defaulting in year 3?
- The probability of default is time-homogeneous, meaning the transition rate from grade B to default is exactly identical in both year 1 and year 3.
- The probability of default in year 3 is determined solely by the obligor's rating at the end of year 2, independent of its rating history prior to that point.
- The probability must be recalculated based on whether the obligor was recently upgraded or downgraded into grade B during the previous rating period considered.
- The probability depends only on the obligor's grade B classification at the start of year 1, regardless of any intervening rating changes occurring throughout year 2.
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