medium · FRM Part 2 Credit Risk
In the context of the Merton model, why is the 'Distance to Default' (DD) usually mapped to an empirical distribution rather than using the standard normal cumulative distribution function (Φ)?
- The normal distribution's tail is considered much too fat, so it overstates the true probability of rare default events.
- The normal distribution model simply cannot properly account for changes in the prevailing risk-free interest rate term structure.
- The normal distribution wrongly assumes that a firm's underlying asset values could become negative at some point, which is economically impossible.
- Empirical default frequencies show that default probabilities are higher for a given z-score than the normal distribution would predict.
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