medium · FRM Part 2 Credit Risk
An analyst is comparing two transition matrices from different economic regimes. Regime X (Expansion) has a 1-year PD of 1% for 'A' rated firms. Regime Y (Recession) has a 1-year PD of 3% for 'A' rated firms. The bank uses a point-in-time (PIT) system.
If the transition matrix is used to build an expected exposure (EE) profile for CVA, how would the 'cliff effect' in a PIT system most likely manifest during a transition from Expansion to Recession?
- The ratings would remain stable, but the risk-neutral hazard rates would increase, leaving the transition matrix unchanged.
- The 2nd-year cumulative PD would decrease because firms that survived the 1st year of the recession are 'hardened'.
- The migration probabilities would decrease as firms become 'stuck' in their current rating due to lack of market liquidity.
- A sudden, simultaneous increase in both the probability of migration to lower grades and the PD within those grades.
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