Financial Risk Manager Part 2
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A credit risk analyst at a bank is using the Merton's model to estimate the probability of default (PD) of a non-dividend-paying company. The company's debt consists of only long-term zero-coupon bonds. The analyst gathers the following information:
| Parameter | Value |
|-----------|-------|
| Value of the company's assets | CAD 400 million |
| Face value of the company's debt | CAD 300 million |
| Expected rate of return of the value of company's assets | 15% |
| Instantaneous volatility of the value of company's assets | 25% |
| Annual interest rate | 3% |
| Remaining time to maturity for the company's debt | 1 year |
What is the PD of the company and a limitation of using the Merton model to predict default of the company?
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.