CFA Level II ExamFixed IncomeHard
A credit analyst is using a structural model to evaluate the credit risk of a company's debt. The model assumes that the company's equity can be viewed as a call option on the company's assets. Which of the following statements is most consistent with the assumptions of this type of structural model, such as the Merton model?
- AThe company's liabilities are represented by a zero-coupon bond maturing at the same time as the debt.
- BThe value of equity is inversely related to the volatility of the company's assets.
- CDefault occurs when the value of the company's assets falls below the face value of its equity.
- DThe model explicitly incorporates macroeconomic factors and industry-specific risks into the default process.
Show answer & explanationAnswer & explanation
Correct answer: A. The company's liabilities are represented by a zero-coupon bond maturing at the same time as the debt.
In the Merton model, the company's debt is simplified to a single zero-coupon bond with a face value equal to the promised payment to debt holders, maturing at a specific time. Default occurs if the asset value is below this debt face value at maturity.
Why the other options are wrong
- B. The value of equity (as a call option) is directly related to the volatility of the company's assets; higher volatility increases option value.
- C. Default occurs when the value of assets falls below the face value of the debt, not equity.
- D. Structural models like Merton's often simplify the default process, typically not explicitly incorporating complex macroeconomic or industry-specific factors into the default trigger itself, focusing more on asset value and debt structure.
Merton Model Assumptions
The Merton model views a company's equity as a call option on its assets and debt as a risk-free bond plus a short put option on the assets, with default occurring if asset value falls below debt value.
- Assets follow a geometric Brownian motion.
- Single zero-coupon debt issue.
- Default only at maturity.
- Equity = Call option on assets.
Memory trick: Merton's debt is zero, equity's a call, assets are the base.