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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank's risk committee notes that its structural model produced very low short-maturity credit spreads for a highly levered but currently solvent firm, while observed market spreads were much higher. Which feature of reduced-form models best explains why they can fit such short-term spreads more readily?

Reduced-form models let default arrive as a surprise governed by a hazard intensity, so short-horizon default probability stays positive. Structural diffusion models push near-term default probability toward zero for a solvent firm, which leads to understated short-maturity spreads compared with observed market levels.

  1. ADefault can occur as a surprise event governed by an intensity, so short-term default probability is not forced toward zeroCorrect
  2. BThey require full knowledge of the firm's balance sheet to determine the default barrier
  3. CThey assume default occurs only at debt maturity
  4. DThey assume asset values follow a deterministic path

Explanation

In classic structural models with diffusion asset values, short-term default probability approaches zero when assets are above the barrier. Reduced-form models use an exogenous intensity, so default can arrive unexpectedly and short spreads can be positive. The other options describe structural-model features or are false.

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