easy · FRM Part 2 Credit Risk
If a firm's leverage increases (Assets V stay same, Debt F increases), how does the Merton model predict the Probability of Default (PD) will change?
- PD will decrease because rising leverage mechanically lowers observed equity volatility.
- PD will decrease since new debt funds growth, cutting overall leverage.
- PD stays the same, because only asset volatility drives the option's moneyness.
- PD will increase because the 'strike price' of the equity call option is higher.
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