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Default Risk Quantitative Methods Guide

Financial Risk Manager (FRM) is a professional designation issued by the Global Association of Risk Professionals (GARP).

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13 views8 pages

Default Risk Quantitative Methods Guide

Financial Risk Manager (FRM) is a professional designation issued by the Global Association of Risk Professionals (GARP).

Uploaded by

me2.chintan
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Topic 20: Default Risk: Quantitative Methodologies Test ID: 8829432

Question #1 of 26 Question ID: 440051

Which of the following credit-scoring models attempts to classify firms as risky or non-risky by using hyperplanes that define a
boundary between groups?

A) Support vector machines.


B) Parametric discrimination.
C) k-nearest neighbor.
D) Linear discriminant analysis.

Question #2 of 26 Question ID: 440052

Which of the following statements is (are) CORRECT?

I. One of the assumptions of the Merton model is that default can occur at any time.
II. Logit and probit models are examples of parametric discrimination.
III. Minimizing the maximum of Type I and Type II errors is an example of the Neyman-Pearson decision rule.
IV. The shape of the line on the GINI curve indicates the success of the classification system.

A) I and IV.
B) II and IV.
C) III only.
D) I, II and III.

Question #3 of 26 Question ID: 440036

Suppose a fixed income portfolio manager buys a risky bond issue with a face amount of $100 million that matures in one year.
To hedge the credit risk that the issuer of the debt will not pay the full amount, the debt holder buys a credit default put on the
value of the issuing firm. What are the payoffs for holding a risky bond and the credit default put, if the value of the risky firm is
$80 million? The risky debt payoff is:

A) $80 million and the credit default put payoff is $20 million.
B) $80 million and the credit default put payoff is $0 because it is out-of-the money.
C) $20 million and the credit default put payoff is $80 million.
D) $100 million and the credit default put payoff is $20 million.

Question #4 of 26 Question ID: 440029

Savid, Inc. has an expected market value of assets in one year of $20 million. The annual volatility of asset returns (standard

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deviation) for Savid has been determined to be $4.2 million. If the distance to default is 2.7, Savid's default threshold is closest
to:

A) $8.66 million.
B) $4.2 million.
C) $6.9 million.
D) $9.43 million.

Question #5 of 26 Question ID: 440048

Which of the following is the main driver of the probability of default in the KMV model?

A) Loan prices.
B) Bond prices.
C) Bond yields.
D) Stock prices.

Question #6 of 26 Question ID: 440028

All of the following are assumptions of the KMV model EXCEPT:

A) bondholders and stockholders cannot negotiate.


B) there is only one issue of debt, all of which matures on a given date.
C) there is no need for an adjustment for liquidity.

D) default can only occur at maturity.

Question #7 of 26 Question ID: 440045

A firm is valued at $1,000,000, and a zero-coupon bond with a $1,200,000 face value is the only debt issued by the firm.
Calculate the value of the firm's equity.

A) $200,000.
B) $0.
C) $1,000,000.
D) −$200,000.

Question #8 of 26 Question ID: 440044

Suppose a firm has two debt issues outstanding. One is a senior debt issue that matures in three years with a principal amount
of $100 million. The other is a subordinate debt issue that also matures in three years with a principal amount of $50 million. The

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annual interest rate is 5 percent and the volatility of the firm value is estimated to be 15 percent. In the Merton model the value of
equity is calculated as:

I. the difference between the value of the firm and the value of senior debt.
II. a call option with an exercise price of $100 million and time to expiration of three years.
III. a call option with an exercise price of $150 million and time to expiration of three years.

the value of the firm less the value of a call option with an exercise price of $100 million and time to
IV.
expiration of three years.

A) II and IV only.
B) I only.
C) III only.
D) I and II only.

Question #9 of 26 Question ID: 440027

The KMV model is most sensitive to estimates of:

A) recovery factors and default rate standard deviations.


B) credit quality of debtors.
C) transition matrices.

D) asset return volatility and correlations.

Question #10 of 26 Question ID: 440037

Under the Merton model, the payoff at maturity to stockholders and bondholders approximates the payoff on a:

Stockholders Bondholders

A) Long call Short put

B) Short call and risk-free bond Long put

C) Long call Short put and risk-free bond

D) Short put Long call

Question #11 of 26 Question ID: 440041

The Merton model is:

A) a structural model but not a value-based model.

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B) a structural model and a value-based model.
C) a value-based model but not a structural model.
D) neither a structural model nor a value-based model.

Question #12 of 26 Question ID: 440049

The KMV model produces a measure called expected default frequency (EDF). Which of the following statements about EDFs is
CORRECT?

A) It decreases when the leverage of the firm falls.


B) It is the risk neutral probability of default from Merton's model.
C) It increases when the stock price of the firm has been rising.
D) It tells investors how the default risk of a bond is correlated with the default risk of other bonds in the
portfolio.

Question #13 of 26 Question ID: 440035

The payoff to the writer of a put is similar to the payoff for a(n):

A) writer of a call on the debtor firm's equity.


B) debtor firm's stockholders.
C) holder of debt.

D) issuer of debt.

Question #14 of 26 Question ID: 440042

In the Merton model, with only debt and equity in the capital structure, the value of equity will increase in value if the:

I. interest rate increases.


II. volatility of firm value increases.
III. value of the firm decreases.
IV. face value of debt increases.

A) I and II.
B) I only.
C) I, II, and IV.
D) III and IV.

Question #15 of 26 Question ID: 440038

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Which of the following statements about the Merton model for probability of default would decrease the probability of a firm
defaulting on its debt? An increase in:

I. firm value.
II. firm value volatility.
III. the expected return on the firm.

A) III only.
B) I and III.
C) I, II, and III.
D) II and III.

Question #16 of 26 Question ID: 440032

Using the Merton model to value the firm's debt and equity, which of the following scenarios is NOT possible? Assume the other
three are true.

I. Equity = 0; Debt = $20.


II. Equity = $10; Debt = $35.
III. Equity = $10; Debt = $20.
IV. Equity = 0; Debt = $35.

A) III only.
B) I only.
C) IV only.
D) II only.

Question #17 of 26 Question ID: 440050

Which of the following includes models in which the assigned score can be interpreted as a probability of default?

A) None of the above.


B) Support vector machines.
C) The k-nearest neighbor approach.
D) Parametric discrimination.

Question #18 of 26 Question ID: 440046

According to the Merton model, which of the following most accurately describes the value of a firm's debt?

A) The payoff is the same as buying a Treasury bill with a face value equal to the firm's only debt issue,
and selling a put on the firm value with an exercise price of the firm's debt.

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B) The payoff is the same as selling a Treasury bill with a face value equal to the firm's only debt issue,
and selling a call on the firm value with an exercise price of the firm's debt.
C) The payoff is the same as buying a Treasury bill with a face value equal to the firm's only debt issue,
and selling a call on the firm value with an exercise price of the firm's debt.
D) The payoff is the same as buying a Treasury bill with a face value equal to one of the firm's debt
issues, and selling a put on the firm value with an exercise price of the firm's debt.

Question #19 of 26 Question ID: 440040

Which of the following is (are) TRUE statements that make predicting the probability of default more difficult for debt that is not
publicly traded?

I. Historical data of debt values is not reliable because of the lack of liquidity for debt instruments.
II. The distribution of debt values is normal.
III. Debt is usually issued by creditors who have equity that is publicly traded.
IV. Debt portfolios are not typically marked to market.

A) III only.
B) I, II, III, and IV.
C) I and IV.
D) I, II, and IV.

Question #20 of 26 Question ID: 440031

Davis, Inc. has an expected return on assets in one year of $12 million. The default threshold has been determined to be $7.5
million, and the annual volatility of asset returns (standard deviation) for Davis has been determined to be 15%. Davis's distance
to default (DD) is closest to:

A) 1.7.
B) 2.5.
C) 1.6.

D) 0.4.

Question #21 of 26 Question ID: 440961

Suppose a firm with a value of $80 million has a bond outstanding with a face value of $100 million that matures in five years.
The current interest rate is 5 percent and the volatility of the firm is 20 percent. If the expected return on the firm is 20 percent
using the Merton model for probability of default, determine the probability that the firm will default on its debt (PD) and calculate
the expected loss given default (LGD).

PD LGD

A) 0.78% $780,000

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B) 6.51% $1,086,000

C) 2.21% $252,000

D) 56.50% $16,629,000

Question #22 of 26 Question ID: 440047

A financial firm has short-term liabilities of $700, long-term liabilities of $1,000, and assets of $2,000. The standard deviation of
asset returns is $200. Compute the distance to default (DD) using the KMV model. (Note: All numbers in $million)

A) 6.5.
B) 5.8.
C) 4.0.
D) 4.5.

Question #23 of 26 Question ID: 440034

In the Merton model, with only debt and equity in the capital structure, the value of debt will decrease and the value of equity will
increase if the:

I. interest rate increases.


II. volatility of firm value increases.
III. value of the firm increases.
IV. value of the firm decreases.

A) II and III.
B) I, II, and IV.
C) I and II.
D) I only.

Question #24 of 26 Question ID: 440043

In the Merton model, where Dm is the value of the firm's debt maturing at time m, and Vm is the value of the firm at time m, which
of the following equations represents the payoffs to debt holders at maturity?

A) Dm - max(Vm - Dm, 0).


B) max(Vm - Dm, 0).

C) Dm - max(Dm - Vm, 0).


D) Vm - max(Dm - Vm, 0).

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Question #25 of 26 Question ID: 440033

In the Merton model, with only debt and equity in the capital structure, the value of debt will increase in value if the:
I. interest rate declines.
II. volatility of firm value increases.
III. value of the firm increases.
IV. volatility of firm value decreases.

A) I and II only.
B) III and IV only.
C) I only.
D) I, III, and IV only.

Question #26 of 26 Question ID: 440030

In the KMV approach, the distance to default (DD) is:

A) the distance between the mean earnings and the debt service payments.
B) estimated based on the value of debt issues.
C) the number of standard deviations between the mean of the firm's asset value distribution and a
specified default point.

D) the multiple of free cash flow divided by interest and principal payments.

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Common questions

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In the Merton model, increasing asset volatility generally increases the value of equity because equity is analogous to a call option on firm assets, where higher volatility raises the option's value. Conversely, debt is likened to a risk-free bond minus a put option, where increased volatility makes it more likely for the put option to be 'in the money,' thus decreasing the debt value .

The default point in the KMV model represents the firm value threshold below which the firm is likely default. A higher default point decreases the distance to default, making it more likely that the firm is perceived as being at risk of defaulting, whereas a lower default point increases the distance to default, suggesting a safer credit profile. Choosing an appropriate default point is critical for accurately reflecting a firm's financial health and likelihood of default .

The Merton model conceptualizes the value of a firm's equity as a call option on the firm's assets. Equity is viewed as a call option where the strike price is the face value of the firm's debt, and the firm's assets are the underlying. Therefore, the payoff to equity holders at maturity is the excess of the firm value over the debt value, if positive .

In the Merton model, equity would be zero at maturity if the firm's asset value is less than or equal to the face value of the debt. This is akin to the scenario where the option expires worthless because the firm's assets are insufficient to cover its debt obligations, rendering the equity holders without any residual value .

Assuming normally distributed asset returns can lead to inaccuracies in the Merton model because asset returns in reality may exhibit skewness and kurtosis. This assumption simplifies the model but may underestimate extreme events or tail risks, potentially impacting the reliability of the estimated default probabilities. Such simplifications might not capture the true dynamics of financial markets, leading to mispricing of risk and misjudging creditworthiness .

Stock prices are a main driver of the probability of default in the KMV model. The model uses the market value of equity and its volatility to calculate the distance to default, which in turn is used to determine the expected default frequency (EDF).

Parametric discrimination models, like logit and probit, provide interpretable coefficients making it easier to understand the influence of individual variables on credit risk, and are useful when the underlying relationships between variables are linear. In contrast, support vector machines (SVMs) can handle non-linear relationships through kernel functions and often achieve higher accuracy by classifying firms using hyperplanes. However, SVMs are less interpretable as they do not provide direct insights into variable influence, making them complex for stakeholders less versed in machine learning .

Assuming that default can only occur at maturity limits the model's ability to account for the probability of interim defaults. This assumption may lead to underestimation of default risk as it ignores any default triggers that may occur before maturity, such as deteriorating financial conditions that could affect a firm's ability to meet obligations. This simplification might not reflect real-world scenarios where companies often face financial distress or default due to cash flow issues or market shocks before the debt maturity date .

The expected default frequency (EDF) in the KMV model is a measure of the likelihood that a firm will default within a given time period. It is significant because it provides investors with a quantifiable metric to assess and compare the default risk of various firms. High EDF values suggest elevated default risk, influencing investors to price risk appropriately, adjust investment portfolios, and make informed decisions regarding credit exposure .

Historical debt value data is unreliable for non-publicly traded debt due to a lack of liquidity in these instruments, which means that market prices may not accurately represent true value or reflect current risk conditions. Furthermore, as non-public debts do not frequently trade, they lack transparent and reliable market-determined valuation, leading to difficulties in assessing credit quality based on past data .

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