Credit Risk Management Practice Exam

Which of the following models is a modified version of the Merton model?

1. CreditMetrics

2. CreditRisk+

3. KMV

4. SpreadRisk

The correct answer is: KMV

The KMV model is a modified version of the Merton model, which is a structural credit risk model. The Merton model uses the value of a firm's assets and their volatility to assess the likelihood of default, treating the firm's equity as a call option on its assets. The KMV model enhances this approach by incorporating actual market information, specifically focusing on the market value of a company's equity and its volatility, to estimate the probability of default more accurately. One key aspect of the KMV model is its use of a distance-to-default metric, which provides a quantitative measure indicating how far a firm's asset value is from the default point. This refinement allows for more responsive and timely assessments of credit risk compared to the traditional Merton framework. In contrast, the other models mentioned do not directly derive from or modify the Merton model. CreditMetrics focuses on portfolio credit risk and uses migration matrices to estimate changes in credit quality. CreditRisk+ is a statistical model that is primarily concerned with assessing default probabilities and loss distribution without a direct linkage to equity structure. SpreadRisk is centered on the analysis of credit spreads and their relationship to credit risk but does not modify the Merton assumptions or framework.