Credit Risk Management Practice Exam

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What describes the cumulative probability of default?

The probability of remaining in the same rating category
The likelihood of moving to a lower rating over time
The likelihood of defaulting at least once over a given period
The probability of improving credit rating

The correct answer is: The likelihood of defaulting at least once over a given period

The cumulative probability of default refers to the likelihood that a borrower, such as an individual, corporation, or government, will default on their debt obligations at least once over a specified time period. This measure takes into account all potential instances of default within that timeframe, which makes it especially useful for assessing long-term credit risk. Understanding this concept is vital since it allows financial professionals to gauge the creditworthiness of borrowers and the overall risk associated with lending or investing in debt instruments. By focusing on the overall likelihood of default happening at least once, this aspect of credit risk offers a more comprehensive view as opposed to just evaluating rating categories or improvements in ratings, which capture different dimensions of creditworthiness but do not directly reflect the risk of default itself. The other choices deal with various states of credit ratings or the likelihood of changes in ratings, which, while important, do not specifically address the concept of cumulative probability of default.