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FRM Part II · FRM Exam Part II · Credit Risk Management

A risk analyst compares a structural (Merton-type) model with a reduced-form (intensity-based) model. Which statement correctly describes a key feature of the reduced-form approach?

In a reduced-form model default is an unpredictable event arriving at an exogenous hazard rate, typically calibrated to bond or CDS spreads, rather than being triggered by asset value falling below a debt threshold as in structural models.

  1. ADefault is triggered when asset value falls below the debt barrier, so it is predictable from the firm's balance sheet
  2. BDefault occurs as an unexpected event governed by an exogenous hazard rate, so it is not predictable from asset valueCorrect
  3. CThe model requires the unobservable asset value and asset volatility as inputs
  4. DDefault can occur only at debt maturity

Explanation

Reduced-form models treat default as a surprise jump driven by an intensity process, usually calibrated to market spreads. The other options describe structural model features: asset value dependence, asset inputs, and (for Merton) default only at maturity.

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