Explanation:
At the end of year 1, there is a 0% chance of default and a 90% chance that the firm will maintain an Aaa rating. In year 2, there is a 0% chance of default if the firm was rated Aaa after 1 year (90% × 0% = 0%). There is a 5% chance of default if the firm was rated Baa after 1 year (10% × 5% = 0.5%). Also, there is a 15% chance of default if the firm was rated Caa after 1 year (0% × 15% = 0%). The probability of default is 0% from year 1 plus a 0.5% chance of default from year 2 for a total probability of default over a 2-year period of 0.5%.
(Book 4, Module 50.2, LO 50.h)
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Question 64
Given the following 1-year transition matrix, which of the following amounts is closest to the probability that an Aaa-rated firm will default over a 2-year period?
| Rating From | Rating To |
|---|---|
| Aaa | |
| Aaa | 90% |
| Baa | 10% |
| Caa | 1% |
A
0.00%.
B
0.23%.
C
0.50%.
D
0.65%.
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