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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A practitioner compares Merton-model default probabilities with agency ratings for a portfolio of listed firms. Which is a recognized limitation of the basic Merton model?

A key limitation is that the basic Merton model permits default only at maturity of a single zero-coupon debt issue, ignoring earlier default triggers and complex capital structures. It does use equity market data and stochastic asset values.

  1. AIt assumes default can occur only at debt maturity and uses a simple capital structureCorrect
  2. BIt cannot use equity market data as an input
  3. CIt requires historical default frequencies to calibrate
  4. DIt assumes asset values are constant over time

Explanation

The basic Merton model allows default only at maturity of a single zero-coupon debt issue, ignoring earlier defaults and complex capital structures. It does use equity prices as inputs and assumes lognormal stochastic asset values, not constant ones.

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