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)?
- Because the normal distribution tail is too fat and overstates the probability of default.
- The normal distribution cannot account for changes in risk-free interest rates.
- The normal distribution assumes asset values can become negative, 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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