Credit Risk Management Practice Exam

What limitation does the Merton model have regarding market values?

1. Inaccessibility of market data

2. Sensitivity to market movements and estimates

3. Inability to track debt levels

4. Dependence on fixed interest rates

The correct answer is: Sensitivity to market movements and estimates

The Merton model, which is used to assess the credit risk of a company by modeling its equity as a call option on its assets, presents certain limitations in how it handles market values. The sensitivity to market movements and estimates highlights that the model relies heavily on current market conditions and assumptions about future volatility and interest rates. Thus, small changes in the underlying parameters can lead to significant variations in the calculated credit risk, making the model particularly susceptible to fluctuations in the market. This characteristic means that the analyses derived from the Merton model are not static and can be affected by moment-to-moment changes in market values, leading to potential inaccuracies in risk assessment if not monitored continuously. Making adaptive judgments based on real-time data, or having precise estimates becomes essential for applying this model effectively in credit risk management. In contrast, other options, such as inaccessibility of market data or inability to track debt levels, do not accurately reflect the core limitation of the Merton model regarding its sensitivity to changing market dynamics and estimates. Furthermore, dependence on fixed interest rates does not capture the broader financial market influences that can affect the model's outputs.