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

A credit analyst compares two modelling families. Model A treats a firm's equity as a call option on its assets and defaults when asset value falls below the debt face value at maturity. Model B treats default as the first jump of a Poisson-type process with a hazard rate calibrated to bond spreads. Which statement correctly classifies these models?

Model A is structural because default is driven by firm asset value falling below debt, as in Merton. Model B is reduced-form because default arrives as an exogenous intensity-driven event calibrated to spreads. Using market data or outputting default probabilities does not define either family.

  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 rely on market prices
  4. DBoth models are reduced-form because both produce default probabilities

Explanation

Merton-type models link default to the firm's asset value relative to its liabilities, so they are structural. Models that treat default as an exogenous intensity-driven event calibrated to market spreads are reduced-form. Using market prices or producing default probabilities does not distinguish the two families.

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