CHAPTER 4: RATING ASSIGNMENT METHODOLOGIES

Question 4.1. Which of the following statements is most accurate in regard to describing a good
rating system?
a. A specific rating system accurately measures the distance from a default event.
b. A verifiable rating system requires backtesting default probabilities on at least a
monthly basis.
c. A homogeneous rating system provides judgments based solely on credit risk
considerations.
d. An objective rating system results in ratings that can be compared across customer
types and market segments.

Question 4.2. In comparing agency rating systems to internal (experts-based) rating systems,
evidence has shown that:
A. internal systems and agency systems are equally compliant in regard to specificity.
B. agency systems are more compliant in regard to verifiability than internal systems.
C. agency systems are less compliant in regard to measurability than internal systems.
D. internal systems are more compliant in regard to objectivity and homogeneity than
agency systems.

Question 4.4. A credit analyst is using linear discriminant analysis (LDA) to determine a Z-
score cut-off for differentiating default from solvency. Assume that the current cut-off point is
1.00, the average default rate is 2.75%, the current assessment of loss given default is 45%, and
the opportunity cost is 15%. What is the new cut-off score after the Z-score cut-off adjustment?
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A. 2.47
B. 3.47
C. 4.66
D. 5.66

Question 4.5. Which of the following methods is typically implemented as the second stage of
principal component analysis?
a. Factor analysis.
b. Divisive clustering.
c. Hierarchical clustering.
d. The canonical correlation method.

Question 4.6. Each of the following items represents an example of qualitative information
that would ideally be captured in assessing default probability except:
A. management’s education and experience.
B. internal controls associated with financial reporting.
C. diversification of products and customers locally and globally.
D. trends in throughput and other operational efficiency metrics.

Question 4.7. Given the following one-year transition matrix, what is the probability that a B
rated firm will default over a two-year period?
Rating to
Rating from
A B C Default
A 90% 5% 5% 0%
B 5% 80% 7% 8%
C 4% 8% 70% 18%
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1. what is the probability that a B rated firm will default over a two-year period?
2. what is the probability that a B rated firm doesn’t fall into any lower rating category at any time
over a two-year period?

Question 4.8. Given the following one-year transition matrix, what is the probability that a Ba
rated firm will default over a two-year period?
Rating to
Rating from
Aaa Aa A Baa Ba B Caa-C Default
Aaa 92.00% 7.00% 0.80% 0.20% 0.02% 0.02% 0.00% 0.00%
Aa 1.32% 90.71% 6.92% 0.75% 0.19% 0.04% 0.01% 0.06%
A 0.08% 3.02% 90.24% 5.67% 0.76% 0.12% 0.03% 0.08%
Baa 0.05% 0.33% 5.05% 87.50% 5.72% 0.86% 0.18% 0.31%
Ba 0.01% 0.09% 0.59% 6.70% 82.58% 7.83% 0.72% 1.48%
B 0.00% 0.07% 0.20% 0.80% 7.29% 80.62% 6.23% 4.79%
Caa-C 0.00% 0.03% 0.06% 0.23% 1.07% 7.69% 75.24% 15.68%

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Question 4.9. De Laurentis explains the annualized default rate (ADR) as follows: "If it is
necessary to price a credit risk exposed transaction on a five year time horizon, it is useful to
reduce the five- year cumulated default rate to an annual basis for the purposes of calculation.
The annualized default rate can be calculated by solving the following equation:
Year 1 2 3 4 5
names (t=0) 1000
names (t) 992 980 970 964 951
Default(t)culmulated,t 8 20 30 36 49
What is nearest to the five year annualized default rate, ADR(5)?

Question 4.10. In the Merton approach to credit risk, default probability is given by this
function (note the formula in De Laurentis is incorrect and should be given as follows):
ln⁡(F) − ln⁡(V) − (μ⁡ − ⁡0.5𝜎 2 )T
PD = 𝑁 ( )
σ√𝑇
Let us make the following assumptions:
The firm's asset value, V(A), is $1.0 billion, The expected asset return, p, is 15.0% , The volatility
of the assets, σ(A), is 25.0%, The face value of debt, F, is $500.0 million and The debt matures
in four years; i.e.., T = 4.0 years. What is the default probability (PD) estimated by Merton?
a) 0.5%
b) 1.0%
c) 2.5%
d) 5.0%

Question 4.11. The exhibit below (displayed in a format similar to De Laurentis) shows the
Altman's Z-score calculation for a hypothetical company:
Profit & Loss statement
Asset & liabilities (000s) $ % (000s) $
Fixed assets $100 31.8% Sales $500.00
Inventories $90 28.7% EBITDA $35.00
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 Receivables $120 38.2% Net financial Expenses $9.75
Cast $4 1.3% Taxes $8.33
Total $314 100.0% Profit $16.92
Capital $80 25.5% Dividends $11.34
Accrued capital Reserves $40 12.7% Accrued Profits $5.59
Financial Debts $130 41.4%
Payables $54 17.2% Equity market value $49.6
Other Net Liabilities $10 3.2%
Total $314 100.0%
1. Shows the Altman's Z-score calculation and Ratio contributions for this company?
Model Ratio contributions for
Ratios Ratio coeff. company ABC
Ratio
(A) (B) (A)*(B) contribution
Working capital/total assets
Accrued capital reserves/total assets
EBIT/total assets
Equity market value/face value of term debt
sales/total assets
Altman's Z-score

2. Assume a stress test that downwardly shocks three of the variables as follows:
Sales decline of 10% , EBITDA decline of 10% and Equity market value decline of 20%. No other
accounts are affected. Which of the following is nearest to the outcome for the updated Altman's
Z-score?
a) Unaffected
b) Z-score drops to 2.95 but the model still predicts safe ("performing"), or at least grey zone
c) Z-score drops to 2.24 and the model predicts distress ("default")
d) Z-score drops to 1.88 and the model predicts distress ("default")

Question 4.12. Your colleague has conducted a principal component analysis (PCA) and
prepared the output below. Principal components
Explaned Cumulative
Components Eigenvalues
variance Variance
COMP1 2.762 39.5% 39.5%
COMP2 1.827 26.1% 65.6%
COMP3 1.098 15.7% 81.2%
COMP4 0.835 11.9% 93.2%
COMP5 0.226 3.2% 96.4%
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 COMP6 0.171 2.4% 98.8%
COMP7 0.081 1.2% 100.0%
Total 7.000 100.0% 200.0%
The variables are financial performance indicators, most of which are income statement and/or
balance sheet ratios. Specifically, return on equity (ROE), return on investment (EBIT/invested
capital), current ratio (CR; current assets/ current liabilities), quick ratio, leverage (MCTI),
market share (SHARE%), and intangibles (R&S%) with the correlation coeff. between original
variables and components:
Ratios COMP1 COMP2 COMP3 Singularity
ROE 0.367 0.875 0.053 0.902 (1-R^2)
ROI 0.486 0.798 −0.100 0.883 0.117
CR 0.874 −0.395 0.057 0.923 0.077
CQR 0.885 −0.314 −0.044 0.883 0.117
MTCI −0.892 0.149 0.196 0.856 0.144
SHARE(%) −0.055 0.259 −0.734 0.609 0.391
R&S(%) −0.215 −0.286 −0.709 0.631 0.369
Each of the following statements is true about this PCA output EXCEPT which is inaccurate?
a) The third component (COMP3) is the current ratio (CR) variable
b) The first four components of the PCA explain over 90.0% of the total variance
c) It is possible to use the components themselves as independent (explanatory) variables in a
linear regression
d) The first and second components (COMP1 and COMP2) are orthogonal to each other; i.e.,
uncorrelated vectors

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