Skip to content

FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A firm's equity is observed with volatility of 40%, equity value of 40, and debt of 60 (face value, treated as the default barrier), so asset value is approximately 100. In a Merton framework, the relationship sigma_E * E = N(d1) * sigma_V * V holds. If N(d1) = 0.80, what is the implied asset volatility?

Implied asset volatility is 20%. Using sigma_V = sigma_E x E / (N(d1) x V) gives 0.40 x 40 / (0.80 x 100) = 0.20. Asset volatility is lower than equity volatility because equity is a leveraged claim on assets.

  1. A20%Correct
  2. B32%
  3. C50%
  4. D16%

Explanation

Solve sigma_V = sigma_E * E / (N(d1) * V) = 0.40 * 40 / (0.80 * 100) = 16/80 = 0.20. Omitting N(d1) gives 16%, and multiplying by N(d1) instead of dividing gives 12.8%-type errors. Dividing 0.40 by 0.80 alone gives 50%.

Did you get it right without looking?

One question tells you little. A timed set on Introduction to Credit Risk Modeling and Assessment shows your real accuracy, how long you take and where you lose marks.

Practise Introduction to Credit Risk Modeling and AssessmentFree diagnostic mock

More Introduction to Credit Risk Modeling and Assessment questions