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FRM Part II · FRM Exam Part II · Credit Risk

A risk manager notes that in a Merton-type model, short-term credit spreads for a highly rated firm with no near-term debt maturity approach zero, while observed market spreads for such firms remain clearly positive. Which feature of reduced-form models best addresses this shortcoming?

Reduced-form models let default arrive as an unpredictable jump with positive intensity, even when assets are far above debt. This produces non-zero short-term spreads, unlike the basic Merton model, where continuous asset diffusion makes near-term default almost impossible.

  1. AThey assume the firm's asset value is directly observable
  2. BThey allow default to occur as a surprise event with a positive intensity even when assets are far above debtCorrect
  3. CThey require default only at debt maturity
  4. DThey eliminate the need to estimate any recovery assumption

Explanation

In the basic Merton model, asset value follows a continuous diffusion, so default over a very short horizon is nearly impossible when assets exceed debt, driving short spreads to zero. Reduced-form models use a hazard rate, so default can occur unexpectedly. They do not require observable assets, do not limit default to maturity, and still need recovery assumptions.

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