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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A risk manager notes that short-maturity credit spreads implied by a classic Merton model are much lower than those observed in the market for investment-grade issuers. Which feature of the Merton framework best explains this shortcoming?

The classic Merton model understates short-term spreads because asset values move continuously and default is possible only at maturity, so a healthy firm has almost no near-term default chance. Reduced-form models allow surprise defaults and match short-dated spreads better.

  1. ADefault can occur only at debt maturity, so the near-term default probability for a healthy firm is very small, since asset value follows a continuous diffusionCorrect
  2. BThe model assumes the recovery rate is zero
  3. CThe model uses the real-world rather than risk-neutral drift
  4. DThe model assumes a stochastic hazard rate

Explanation

With continuous diffusion asset values and default only at maturity, a firm far above its debt has almost no chance of default over a short horizon, so the model-implied spread tends to zero as maturity shrinks. Reduced-form models allow sudden default surprises and fit short spreads better. Recovery is not assumed zero in the model.

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