Essays

CAIA Level 2 — Essay Questions

Essay 1 — Reading 5.1

A hedge fund manager, who is considering taking risky debt positions, decides to determine the credit spread on MarShen, Inc.'s risky debt using Merton's structural credit risk model. MarShen, Inc. has $500 million worth of assets and volatility of assets of 16%. The company has a 4-year zero-coupon bond valued at $86 million, with a face value of $110 million, a default intensity of 7.2%, and an estimated recovery rate of 68%. The annual risk-free rate is 3.5%.

Question AChapter 5.1LO 5.1.62 points

Under Merton's model, (1pt each) i. What are the components of the value of the firm's assets? ii. In the event that MarShen defaults, what is the potential loss faced by MarShen's bondholders?

Question BChapter 5.1LO 5.1.62 points

What is the credit spread of MarShen's bond?

Question CChapter 5.1LO 5.1.61.5 points

Under Merton's model, what is the value of the put option given to MarShen's stockholders?

Question DChapter 5.1LO 5.1.61 point

Indicate how the probability of default for MarShen's bond changes as the company's asset volatility increases and as the bond's time to maturity decreases.

Question EChapter 5.1LO 5.1.51.5 points

i. 0.5pts: State a parameter in the Merton model that is not readily observable. ii. 1pt: Other than unobservable model parameters, state a shortcoming of the Merton model.

Question FChapter 5.1LO 5.1.82 points

If the hedge fund manager decides to use the reduced-form credit risk model, what would be the credit spread of MarShen's bond? In this case, what would be the probability of MarShen defaulting within the next four years if its default intensity is 6.3%?