Workshop 4.docx - Credit Risk Analysis and Management...

Credit Risk Analysis and Management
UMAD5W-15-3
Week 4 Workshop
Task 1
One of the outputs of the Merton model is the distance to default given by the expression:
Given that the value of a company, North Star Inc. is £250,000 (i.e. the market value of its
assets). Further, the current market value of its liabilities stands at £220,000 with a default
point of £200,000. At the end of a one-year horizon, the volatility of the company’s assets is
25%, with an expected return of 20%.
What is the probability that the company’s assets value will fall within the default tail of the
assumed normal distribution in one-year?
Task 2
Given that the market value of a firm’s assets is £1m at time t=0. The firm sets its default
threshold at £600,000 which represents all the short term liabilities and one-half of its long
term liabilities. Following the structural model’s assumption which states that a firm will
default if the value of the assets fall below that of its debt, estimate the probability of
default over a time t=1.
(Assumptions: volatility of assets σ= 25%; growth of asset μ = 20%; time to maturity = 1
year).
Task 3