Week 4: Probability of default (Part 2)

In this chapter we discuss the following:

1. Mertons Model
2. KMV
TASK CRITERIA: 10 marks
Due date
Task

2016

Marks

Number
1
3
2
3
3
2
jeanpierre.fenech@monash.edu

6.00pm on the 15th August

by

email

to:

TASK 4.1:
What type of company is assumed in Merton's model?

Private company
Public company
Limited company
All type of companies are ok.

What type of default model is Merton's model ?

Structural model
Instrumental model
Mixture model
Fundamental model.

Week 4 questions: Probability of default (Part 2)

Mertons model
has been introduced by Prof. Dr. Merton in 1994
is the basis for many influential industry models, such
as KMV and CreditMetrics
is a threshold model
assumes that default can happen at every time between
today and maturity T
is no longer used by practitioners
We take into consideration a company, whose equity is $11million.
The companys debt is equal to $18million and it must be paid in
one year. The risk free rate on the market is 6% per annum. The
observed volatility of equity is 0.7.
What is the PD (% expressed rounded off to the 2 nd decimal) of the
company according to Mertons model?
5.48%
What is the PD if the companys debt decreases to $15million?
4.84%
Assume y = 0.3 a nd = 15. The risk-free rate on the market is 6% per annum, and
T=1. What should be the market value of the company today, V0 , in order to have a 1year PD equal to 2%, according to Mertons Model?
27.36254

Week 4 questions: Probability of default (Part 2)

NUMERICAL INPUT
Consider a publicly traded company whose equity is $8 million. The
volatility of equity is 75%. The company's debt is equal to $7.5
million and it must be paid in 1 year. The risk-free rate on the
market is 6% per annum. Answer the following (round off to the
second decimal place, e.g. 1.1234 to 1.12; 1.1265 to 1.13.
What is the probability of default (in % but without the % sign) of
the company in 1 year?
5.00
What is the probability of default (in % but without the % sign) in
one year, if debt is equal to $14 million?
7.69
Which of the following sentences are true?
The PD in Merton's model increases in the amount of debt
The PD in Merton's model is always smaller than 20%.
Merton's model assumes that we live in a Gaussian
world.
In Mertons model, the value of equity at maturity T
corresponds to the payoff of an American call option on VT
In Mertons model, default corresponds to the
liquidation of the company.

Week 4 questions: Probability of default (Part 2)

Task 4.2
Moodys KMV model is:

A proprietary model
A F-IRB model only
Derived from Mertons model
Extensively based on actual and historical data
A model based on the computation of a quantity called PD

Select the right answer(s):

The distance to default is a key quantity in Mertons model
In Moodys KMV Model, two different companies with
the same DD have the same EDF.
The EDF is the probability that a company will default during
year 2, provided it has not defaulted at the end of year 1,
according to Moodys KMV.
Mertons model is extensively used by risk managers in
their daily assessment of credit risk.

Check the FALSE statements:

The KMV model derives from Merton's one
Merton's model derives from the KMV one
The EDF and the BB are two fundamental quantities in
the KMV model
KMV model has been the most used model for credit
risk in the 70's
The KMV model is a structural model of default.

Week 4 questions: Probability of default (Part 2)

In the KMV model, the empirical function used to estimate the EDF
of a company is:

quadratic in DD
Gaussian
strictly convex
Decreasing

The EDF (Expected Default Frequency) of a company in the KMV

model is:
The probability that the company will default in 1 year
The probability that the company will default within 1
year
The probability that the company will not default within 1 year
The probability that the company will default after 1 year.

Week 4 questions: Probability of default (Part 2)

TASK 4.3
This section tests your knowledge with respect to the Black-Scholes
Model Option Pricing Model. We have not covered it extensively,
however it is designed to challenge your knowledge about this
model, which Merton used to calculate PD. Therefore, I expect you
to carry out some further reading to be able to reply to such
questions.
1.

In the Black-Scholes Option Pricing Model, what is the minimum and

maximum value of N(d1)?
minus infinity to plus infinity
minus infinity to zero
minus one to zero
zero to plus infinity

2.

In the Black-Scholes Option Pricing Model, if interest rates rise, the

price of a call option will
decline.
remain unchanged.
increase.
decline, then increase.

3.

All of the following are assumptions of the Black-Scholes Option

Pricing Model except
a. markets are efficient.
b. no dividends.
c. interest rates are constant.
d. investors are generally bullish.

4.
a.
b.
c.

The expected volatility of the underlying asset is known as

sigma.
delta.
gamma.

Week 4 questions: Probability of default (Part 2)

d.
5.
a.
b.
c.
d.
6.

Option value is mostly concerned with

historical volatility
average daily volatility.
expected future volatility.
market average volatility.

a.
b.
c.
d.

If volatility increases, call premiums _____ and put premiums _____.

increase, increase
increase, decrease
decrease, increase
decrease, decrease

a.
b.
c.
d.

A method of adjusting for cash dividends is the _____ model.

Fisher
Sharpe
Merton
Miller

7.

8.

theta.

Everything else being equal, an American option will sell for

________ a European option.
a.
more than
b.
less than
c.
the same as
d.
None of the above; cannot be determined

9.
a.
b.
c.
d.
10.
a.
b.
c.
d.

The Black-Scholes model assumes a _____ distribution.

lognormal
uniform
triangular
Poisson
Which of the following is most accurate?
Implied volatility is usually less than historical volatility.
Implied volatility is usually greater than historical volatility.
Implied volatility is usually equal to historical volatility.
There is no reliable connection between historical and implied
volatility.

Week 4 questions: Probability of default (Part 2)