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

A risk analyst compares structural (Merton-type) and reduced-form credit models. Which statement correctly describes the reduced-form approach?

In reduced-form models default is a surprise event whose arrival is governed by an exogenously specified hazard rate or intensity process, typically calibrated to market spreads. Asset-value thresholds and leverage-based default describe structural models, not reduced-form ones.

  1. ADefault is triggered when the firm's asset value falls below the face value of debt at maturity
  2. BDefault is an unpredictable event whose arrival is governed by an exogenous intensity (hazard rate) processCorrect
  3. CDefault probabilities are derived solely from the firm's balance sheet leverage and asset volatility
  4. DDefault occurs only on scheduled debt payment dates and is fully predictable from asset values

Explanation

Reduced-form models treat default as a surprise event driven by an exogenously specified intensity process, calibrated mostly to market prices such as bond or CDS spreads. Options describing asset-value thresholds and leverage-driven default describe structural models.

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