Suppose there are two ratings categories: A and B, along with default. The ratings-migration probabilities look like this for a B-rated loan:
Rating in 1 year
Probability
A 0.05 B 0.9 Default 0.05
The yield on A rated loans is 5%; the yield on B rated loans is 10%. All term structures are flat (i.e. forward rates equal spot rates). A loan in default pays off 50%.
b. Compute next year’s mean value for each loan.