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FRM Part I · FRM Exam Part I · Measuring Credit Risk

Which statement best describes how reduced-form (intensity-based) credit models differ from structural models such as Merton's?

Reduced-form models treat default as an exogenous random event arriving at a hazard (intensity) rate, which is calibrated to market credit spreads. Structural models instead link default to firm asset value falling below debt, so the other descriptions apply to Merton-type frameworks.

  1. ADefault is triggered when asset value falls below the debt level, so default is predictable from firm value
  2. BDefault is modeled as an exogenous random event governed by a hazard rate, which can be calibrated to observed bond spreadsCorrect
  3. CDefault requires the firm's equity to be modeled as a put option on its assets
  4. DDefault probabilities are derived solely from the firm's balance sheet leverage and asset volatility

Explanation

Reduced-form models treat default as a surprise arrival of a Poisson-type process with an intensity that is typically calibrated to market prices of bonds or CDS. The other options describe the structural approach, in which default is tied to asset value relative to liabilities.

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