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

A risk analyst compares structural and reduced-form approaches to modeling default. Which statement best describes the reduced-form (intensity-based) approach?

Reduced-form models treat default as a random, unpredictable event whose arrival is governed by a hazard rate, which is typically calibrated to market credit spreads. Structural models instead link default to the firm's asset value falling below a debt threshold.

  1. ADefault occurs when the firm's asset value falls below a debt barrier, so default is predictable from the asset process
  2. BDefault is modeled as an unpredictable event arriving at a random time governed by a hazard rate, often calibrated to market spreadsCorrect
  3. CDefault probability is derived solely from the firm's balance sheet leverage and asset volatility
  4. DDefault happens only at debt maturity when assets are less than face value of debt

Explanation

Reduced-form models treat default as a surprise event driven by an intensity (hazard rate) process, usually calibrated to bond or CDS prices. The first and third options describe structural (Merton-type) logic based on firm value, and the fourth is the Merton maturity-only default feature.

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