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

Which statement best distinguishes reduced-form credit models from structural (Merton-type) models?

Reduced-form models treat default as a surprise event governed by an exogenous hazard rate, usually calibrated to observed bond or CDS spreads, whereas structural models link default to the firm's asset value falling below its debt. Asset value inputs belong to structural models.

  1. AReduced-form models treat default as an unpredictable event driven by an exogenous intensity process, calibrated to market spreads, rather than being tied to asset value falling below debtCorrect
  2. BReduced-form models require the firm's asset value and asset volatility as direct inputs
  3. CReduced-form models imply default is perfectly predictable from the firm's leverage
  4. DReduced-form models cannot be used to price credit default swaps

Explanation

Reduced-form models specify a default intensity (hazard rate) that is typically calibrated to bond or CDS spreads, so default occurs as a surprise. Asset value and volatility inputs are characteristic of structural models, and structural models give a more predictable default linked to leverage. Reduced-form models are widely used for CDS pricing.

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