medium · FRM Part 2 Credit Risk
A bank uses the Merton structural model to estimate the Probability of Default (PD) for a levered firm. The analyst is provided with the firm's equity volatility σ_E = 60% and needs to input a volatility into the Distance to Default (DD) formula.
Which of the following actions is correct according to the model's design?
- The analyst should use the simple average of σ_E and the prevailing risk-free rate.
- The analyst should use σ_E directly, since default risk is inherently a property of the equity price.
- The analyst must back out the asset volatility σ_V, as σ_E overstates the risk for a levered firm.
- The analyst should use the volatility of the firm's own bonds, i.e. the 'spread volatility'.
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