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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A risk analyst uses the Merton framework to estimate default probability for a listed firm. Which pair of inputs does the analyst typically need to infer because they cannot be observed directly in the market?

The analyst must infer asset value and asset volatility, since they are not directly observable. They are solved simultaneously from observed equity value and equity volatility using the option relationships linking equity to the firm's assets.

  1. AEquity value and face value of debt
  2. BAsset value and asset volatilityCorrect
  3. CRisk-free rate and debt maturity
  4. DEquity volatility and equity value

Explanation

Equity value, equity volatility, debt face value, maturity and the risk-free rate are observable or contractual. Asset value and asset volatility are not observed, so they are solved for from the equity value and equity volatility using the option pricing equations relating equity to assets.

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