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

A risk analyst compares two firms with identical asset value and identical zero-coupon debt face value and maturity in a Merton framework. Firm X has higher asset volatility than Firm Y. Holding everything else constant, which statement is correct?

Firm X has higher equity value and a wider credit spread. Equity is a call on assets, so higher asset volatility raises its value, and with asset value fixed the risky debt value falls, which increases the spread.

  1. AFirm X has lower equity value and a higher credit spread
  2. BFirm X has higher equity value and a higher credit spreadCorrect
  3. CFirm X has higher equity value and a lower credit spread
  4. DFirm X has lower equity value and a lower credit spread

Explanation

Equity is a call option on assets, and call value rises with volatility. Since total asset value is fixed, debt value falls, so the credit spread widens. Lower equity value would contradict option vega being positive.

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