Credit Risk Models

[TraderGod]

1. Ignatius Reilly, CFA, is running an MDA model to predict corporate bankruptcy. Using Altman Z-score model gives him a Z-score of 3.5. Ignatius believes this indicates a healthy firm. Is Ignatius correct?
A. Yes
B. No, Z-Score models are not applicable here
C. No, the Z-Score is not below the 1.81 threshold which indicate a healthy firm
D. No, the Z-Score is not above the 4 threshold which indicates a healthy firm
2. Ignatius then runs two credit risk models on the company: a structural model and a reduced form model.
Ignatius tells his boss Abe Froman, “structural models are also known as ‘firm-value models’ and show that a default can be modeled as an option to the stockholders granted by the bondholders and as a result the same principles used for option pricing can apply to the valuation of risky corporate securities.”
Abe disagrees with Ignatius’ conclusions about structural models.
Abe then adds, “unlike structural models, a reduced form model does not look inside the firm, but directly model the probability of default or downgrade.” Is Abe right about structural models and reduced form models?
…Structural Models…Reduced Form
A. Yes…………….Yes
B. Yes…………….No
C. No……………..Yes
D. No……………..No
T/G

 

[cfasf1]

dude. did i miss a section?

 

[Niblita75]

This is why I hate you so much haha.

 

[cfasf1]

no. really. wtf?

 

[Niblita75]

Ill guess
B
C
If I get one right i’ll be set.

 

[barthezz]

first no idea ( edit: healthy )
second A
edit:
altman found that a scores less than 1.81 indicate firms with serious credit problems while firms with a score above 3 are healthy.
Z - model: 1.2x1+1.4X2+3.3X3+0.6X4+1.0X5
where
x1 - working capital to total assets
x2 - RE / total assets
x3 - EBIT / total assets
x4 - market value of equity / total liablities
x5 - sales/ total assets

 

[thepinkman]

Um. What that hell is this crap! Schweser pg number please!

 

[Niblita75]

Probably not in Schweser.

 

[mumukada]

B for the first one..
just for kicks…
not sure about structural model, but the reduced form sounds vaguely familiar…and that statement seems correct..so either A or C

 

[thepinkman]

What pg in the readings then? Or study session? Or something dammit!

 

[barthezz]

for all the fellow students:
CFA book 5, page 39

 

[TraderGod]

Not in Schweser. What good would that do - you’ve guys have already gone through the Qbank. These ones I’ve written, the reference is CFA Vol 5, pg 39-41
A is correct. Altman found that Z-scores less than 1.81 indicated a firm with serious credit problems while a Z-score in excess of 3.0 indicated a healthy firm.
C is correct. Abe is not correct to disagree with Ignatius about the structural model which do show that a default can be modeled as an option to the stockholders granted by the bondholders and as a result the same principles used for option pricing can apply to the valuation of risky corporate securities.”
Abe is correct about reduced form models which do not look inside the firm, but directly model the probability of default or downgrade. Two popluar versions are the Jarrow and Turnbull model; and the Duffie and Singleton model.
T/G

 

[mumukada]

we’re screwed….

 

[barthezz]

oops.. read the second wrong.. both models are correct just the question asks about abe argumentation