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FRM Part II · FRM Exam Part II · Credit Value at Risk

In a Merton framework, a bank holds a one-year zero-coupon bond of a firm. All else equal, the firm's asset volatility rises from 20% to 35% while asset value and debt face value are unchanged. Which outcome is expected?

Equity value rises and the credit spread widens. Equity is a call on assets, which gains value when volatility increases. With total asset value fixed, the gain to shareholders comes at the expense of debt holders, so debt value falls and spreads widen.

  1. AEquity value falls and the credit spread on the debt narrows
  2. BEquity value rises and the credit spread on the debt widensCorrect
  3. CEquity value rises and the credit spread on the debt narrows
  4. DEquity value and debt value both rise because total asset value is unchanged

Explanation

Equity is a call option, whose value increases with volatility. Since V = E + D is unchanged, debt value falls, so its yield and credit spread widen. Debt holders are effectively short the option. Both rising is impossible when total value is fixed.

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