Credit Risk Management Practice Exam

What distinguishes cumulative from marginal default probabilities?

1. Cumulative is constant while marginal is increasing

2. Cumulative is increasing and marginal is decreasing

3. Both are constant

4. Cumulative is decreasing and marginal is increasing

The correct answer is: Cumulative is increasing and marginal is decreasing

Cumulative default probabilities represent the likelihood that a borrower will default at any point in time up to a certain time horizon. This means that as time progresses, the cumulative probability increases because it aggregates all default probabilities from the past up to the current time frame. Thus, the concept of cumulative default probabilities inherently reflects an increasing trend over time. On the other hand, marginal default probabilities indicate the likelihood that a borrower will default at a specific point in time, considering they have not defaulted prior to that point. As time goes on, these marginal probabilities can show a decreasing trend, especially in the context of credit risk, since the longer a borrower remains non-defaulting, the less likely they may be to default at a future date. This distinction is crucial for financial institutions and credit analysts as it helps in assessing the overall credit risk of a portfolio over time. Understanding the relationship between cumulative and marginal probabilities allows for better risk management and the implementation of appropriate strategies in response to changing credit conditions and borrower behavior.