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FRM Part II · FRM Exam Part II · Credit Risk

A credit analyst compares two approaches to modeling a corporate borrower's default. Model A treats the firm's equity as a call option on its assets and triggers default when asset value falls below the debt face value at maturity. Model B specifies default as the first jump of a Poisson-type process with an intensity that depends on market variables. Which statement correctly classifies these models?

Model A is structural because default is tied to the firm's asset value falling below its debt, as in the Merton model. Model B is reduced-form because default arrives as an exogenous jump governed by an intensity process, not by the firm's balance sheet.

  1. AModel A is a structural model and Model B is a reduced-form modelCorrect
  2. BModel A is a reduced-form model and Model B is a structural model
  3. CBoth models are structural because both use market data
  4. DBoth models are reduced-form because both produce a default probability

Explanation

Merton-type models link default to the firm's asset value relative to its liabilities, so they are structural. Intensity models treat default as an unexpected event driven by a hazard rate, so they are reduced-form. Using market data or producing a default probability does not distinguish the two classes.

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