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:
- The 1st-year PD is increased by roughly 50%, since PD and LGD tend to move together in stress.
- The matrix is recalculated using risk-neutral hazard rates so LGD feeds into the PD estimate.
- Ignore the LGD data, as LGD affects expected loss and capital but not the default probability itself.
- The calculated cumulative PD figure is multiplied by 1.5 to reflect the increased loss severity under stress.
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