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IAI Actuarial Core Principles · Economic Modelling · Simple models for credit risk

In a reduced form (intensity-based) model of credit risk, the time of default is modelled as the first jump of a Poisson-type process with a hazard rate (intensity). Which statement best describes how default is treated in this framework?

In reduced form models default is an unpredictable event arriving at a random time with an exogenously specified hazard rate. This contrasts with structural models, where default is triggered when firm asset value falls below a threshold such as debt.

  1. ADefault occurs when the firm's asset value first falls below its debt, so it is predictable from the firm's balance sheet
  2. BDefault is an unpredictable event that occurs at a random time governed by an exogenously specified intensityCorrect
  3. CDefault can only occur on a coupon date and is determined by the credit rating agency
  4. DDefault happens with certainty at the maturity of the bond if the recovery rate is below 100%
  5. Default probability is zero until the firm's equity value reaches zero

Explanation

Reduced form models treat default as a surprise event whose arrival is driven by an exogenous hazard rate, not by the firm's asset value. Option 0 describes a structural (Merton-type) model instead.

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