Credit Risk Management Credit Risk Modeling 1 — Questions and Answers
Question 1: Which model uses a firm's asset value and volatility to estimate the probability of default?
- Altman Z-Score
- Merton structural model (Correct answer)
- CreditMetrics
- Logistic regression
Correct answer: Merton structural model
The Merton structural model treats equity as a call option on the firm's assets, deriving default probability from asset value and volatility.
Question 2: In the Altman Z-Score model, a score below 1.81 for a manufacturing firm typically indicates what?
- Low credit risk
- Moderate credit risk
- High distress zone (Correct answer)
- Investment grade status
Correct answer: High distress zone
Altman's original Z-Score places firms with a score below 1.81 in the 'distress zone,' indicating a high probability of bankruptcy.
Question 3: What does the term 'PD' stand for in credit risk modeling?
- Portfolio Duration
- Probability of Default (Correct answer)
- Partial Disclosure
- Payment Delay
Correct answer: Probability of Default
PD (Probability of Default) is the likelihood that a borrower will fail to meet its debt obligations over a specified time horizon.
Question 4: In logistic regression credit scoring, what is the output variable range?
- −∞ to +∞
- 0 to 100
- 0 to 1 (Correct answer)
- −1 to 1
Correct answer: 0 to 1
Logistic regression uses the sigmoid function to constrain output between 0 and 1, making it suitable for modeling default probabilities.
Question 5: Which of the following is a reduced-form credit risk model?
- Merton model
- KMV model
- Jarrow-Turnbull model (Correct answer)
- Altman Z-Score
Correct answer: Jarrow-Turnbull model
The Jarrow-Turnbull model is a reduced-form model that treats default as a Poisson process with an intensity driven by market variables.
Question 6: What is the 'through-the-cycle' (TTC) approach to PD estimation?
- PD estimates that vary with each economic cycle phase
- PD estimates averaged across an entire economic cycle (Correct answer)
- PD based only on current market conditions
- PD derived from equity market prices
Correct answer: PD estimates averaged across an entire economic cycle
TTC PD estimates reflect long-run average default rates across full economic cycles, reducing procyclicality in capital requirements.
Credit Risk Management Credit Risk Modeling 1
Which model uses a firm's asset value and volatility to estimate the probability of default?