Credit Risk Management Practice Exam

What is the fundamental premise behind the Merton model?

1. Default occurs when income drops below a threshold

2. Default occurs when equity is no longer seen as valuable

3. Default occurs when debt levels exceed assets

4. Default occurs due to market fluctuations only

The correct answer is: Default occurs when equity is no longer seen as valuable

The Merton model is rooted in the concept of firm value and how it relates to equity and debt. The fundamental premise behind the model is that default occurs when the value of a company's assets falls below the value of its liabilities, implying that the equity is no longer valuable. In this framework, equity holders benefit from the upside potential of the firm's value but face total loss when the firm's asset value drops significantly and cannot cover the debt obligations. When the firm's asset value is greater than its liabilities, equity has value and the firm is financially viable. Conversely, when the asset value falls below the liabilities, equity holders will not receive any value, leading to a situation where default is imminent. Hence, the understanding that default occurs when equity is no longer seen as valuable reflects the central theory behind the Merton model. This perspective distinguishes it from other options which either misinterpret the conditions for default or simplify the dynamics involved in firm valuation and credit risk.