Answer: 4.5%

**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%.

Author: LeetQuiz Editorial Team