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FRM Part II · FRM Exam Part II · Credit Risk

A credit analyst compares two approaches to modeling default of a listed manufacturing firm. Approach A models default as the point at which the firm's asset value falls below its debt obligations at maturity. Approach B models default as an unpredictable event arriving at a random time governed by an intensity. Which statement correctly classifies these approaches?

Approach A is a structural model because default is tied to firm asset value falling below debt, while approach B is a reduced-form model because default arrives as an unpredictable event governed by a hazard rate (intensity) rather than by balance sheet dynamics.

  1. AA is a structural model and B is a reduced-form modelCorrect
  2. BA is a reduced-form model and B is a structural model
  3. CBoth A and B are structural models
  4. DBoth A and B are reduced-form models

Explanation

Structural (Merton-type) models link default to the firm's asset value relative to its liabilities. Reduced-form (intensity) models treat default as a surprise event driven by a hazard rate, not tied to asset value. So A is structural and B is reduced-form.

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