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FRM Part II · FRM Exam Part II · Credit Risk

A risk manager notes that short-term credit spreads for investment-grade issuers in Merton-type models are typically close to zero, yet observed short-maturity spreads are materially positive. Which feature of reduced-form models best addresses this?

Reduced-form models generate positive short-maturity spreads because default arrives as a surprise governed by a hazard rate, so short-horizon default probability is not negligible. Diffusion-based structural models imply near-zero short-term spreads when assets comfortably exceed debt.

  1. ADefault can occur as a sudden surprise, so short-term default probability is not negligibleCorrect
  2. BDefault is triggered only at debt maturity
  3. CAsset values follow a continuous diffusion process with no jumps
  4. DRecovery is assumed to be zero in all states

Explanation

In a diffusion-based structural model with assets well above debt, the chance of reaching default over a short horizon is near zero, so spreads vanish at short maturities. Reduced-form models use a hazard rate that can produce default unexpectedly at any time, generating positive short-term spreads. The other options describe structural features or are untrue.

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