Explanation:

To calculate the two-period cumulative probability of default for a B-rated bond:

1. First period probability of default: 2%

2. Second period probability of default: This is the probability of surviving year 1 and defaulting in year 2.

   • Year 2 probability of default = (0.03 × 0.00) + (0.90 × 0.02) + (0.05 × 0.14) = 2.5%
   • Where:
     • 0.03 = probability of upgrade
     • 0.90 = probability of staying at B rating
     • 0.05 = probability of downgrade
     • The corresponding default probabilities for each rating state

3. Cumulative probability of default = First period PD + Second period PD = 2% + 2.5% = 4.5%

Therefore, the two-period cumulative probability of default is 4.5%.