Financial Risk Manager Part 2
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Ultimate access to all questions.
Consider a non-dividend-paying firm for which you need to determine the probability of default (PD) using Merton's model. The given data includes:
Using this data, calculate the probability of default for the firm according to Merton's model. Furthermore, discuss a potential drawback of utilizing Merton's model for predicting the company's default risk.
A
The company's PD is 3.03%, and a limitation of the Merton model is that it cannot be applied to debt holdings maturing in more than 1 year.
B
The company's PD is 4.04, and a limitation of the Merton model is that it only applies under the assumption that the value of the firm is normally distributed.
C
The company's PD is 5.20%, and a limitation of the Merton model is that it is costly, especially for smaller firms, to continuously calibrate PD on historical series of actual defaults.
D
The company's PD is 12.49%, and a limitation of the Merton model is that it is not capable of continuously calibrating PD due to continually changing movements in interest rates and market prices.