P1.T4.918. Internal versus external credit ratings (de Servigny Ch.2)

Nicole Seaman

Director of FRM Operations
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Learning objectives: Explain the potential impact of ratings changes on bond and stock prices. Compare external and internal ratings approaches. Explain and compare the through-the-cycle and at-the-point internal ratings approaches.

Questions:

918.1. Dorthy the Senior Risk Analyst is developing an internal rating system for her company. Her first attempt is to infer default probabilities from a Merton model and then map those to categorical ratings. In a sample use case, the firm's asset value, V(A) = $12.511 billion, asset volatility, σ(A) = 9.0%, the default threshold is$10.0 million. The expected return on assets, ROA = +5.0%, and the credit horizon is 1.0 year. The question does NOT require utilizing these calculations.

For this firm, she consequently computes a distance to default (DD) of 3.0 and because the asset returns are presumed normally distributed, she infers a default probability of N(-DD) - N(-3.0) = 0.135%. As a final step, she will assign a credit risk grade of seven (7) to the firm because seven corresponds to the bin where PD = {0.10% to 0.20%}. Which of the following statements about her approach is most likely to be TRUE?

a. Her default probability is probably too low
b. Her approach can be characterized as through-the-cycle (TTC)
c. The primary weakness of her approach is that it will not be a reliable component in an early-warning system
d. The primary advantage of her approach is that, because systematic risk is omitted, false starts are very unlikely

918.2. Consider the following four banks, each of which has some requirement(s) for credit ratings:
• Bank A will use Basel's standardized approach (SA) to credit risk
• Bank B prefers to avoid time horizon bias, homogeneity bias, and and principal-agent bias
• Bank C has a mission-critical credit risk function and requires a system that provides a consistent evaluation across its divisions
• Bank D will use a sophisticated Basel approach to credit risk and has the ability to numerically specify the probability of default (PD) parameter
In a choice between external and internal credit ratings, which is required by these banks?

a. All four banks require external ratings
b. All four banks are indifferent between (can use either) internal or external ratings
c. Banks A and B prefer external ratings, while Banks C and D need internal ratings
d. Banks A and B prefer internal ratings, while Banks C and D need external ratings

918.3. In regard to through-the-cycle (TTC) versus at-the-point (aka, point in time, PIT) approaches to credit ratings, each of the following statements is true EXCEPT which is false?

a. Agency (i.e., external) credit ratings tend to be through-the-cycle (TTC)
b. Through-the-cycle (TTC) is conditional, while at-the-point (PIT) is unconditional
d. During crisis periods, PIT approaches imply higher expected and unexpected loss (EL & UL) such that PIT tends to be pro-cyclical