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

Which statement about the Merton model is correct?

The Merton model allows default only at debt maturity, when the asset value is below the debt's face value. Recovery is determined by the remaining assets, not fixed exogenously. Barrier-based early default belongs to extensions, and Poisson-arrival default belongs to reduced-form models.

  1. AIt assumes the firm can default at any time before maturity when assets hit a barrier
  2. BIt assumes default can occur only at debt maturity, when assets are below the face value of debtCorrect
  3. CIt assumes the recovery rate is an exogenous fixed fraction of face value
  4. DIt models default as an unpredictable event arriving at a Poisson rate unrelated to firm assets
  5. It requires the firm's equity to be non-tradable

Explanation

Merton's model has default only at maturity, when assets are below the debt's face value, and recovery is endogenous (the asset value). Barrier default is the Black-Cox extension. Fixed recovery and Poisson default are features of reduced-form models.

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