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

A risk analyst compares credit modeling frameworks. Which statement correctly distinguishes a structural model (Merton type) from a reduced-form (intensity-based) model?

Structural models tie default to the firm's asset value dropping below its debt obligation, whereas reduced-form models treat default as a surprise event governed by a hazard rate (intensity) that can be calibrated to observed credit spreads, without modeling firm assets explicitly.

  1. AStructural models treat default as an exogenous surprise driven by a Poisson process, while reduced-form models link default to firm asset value falling below debt
  2. BStructural models link default to the firm's asset value falling below a debt threshold, while reduced-form models treat default as an unexpected event governed by a hazard rateCorrect
  3. CBoth frameworks require the firm's asset value to be observable and modeled directly
  4. DReduced-form models cannot be calibrated to market credit spreads, whereas structural models always can

Explanation

In Merton-type structural models default occurs when asset value is below the debt claim at maturity. Reduced-form models model default as the first jump of a process with an intensity (hazard rate), calibrated to market spreads. Option A reverses the two definitions.

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