Chartered Financial Analyst (CFA) Practice Exam Level 2

Which model explains default occurrence through balance sheet assessment?

1. Reduced Form Models

2. Structural Models

3. Credit Ratings

4. Local Expectations Models

The correct answer is: Structural Models

The structural models are fundamentally designed to assess the likelihood of default by evaluating the underlying balance sheet of a firm. These models operate on the premise that a company's equity can be viewed as a call option on its assets, where the firm is assumed to default if its asset value falls below a certain threshold (typically the level of its liabilities). By modeling the dynamics of asset values and the volatility associated with them, structural models facilitate the estimation of default probabilities based on the financial health of the company as reflected in its balance sheet. This framework is particularly intuitive as it connects observable market data, such as equity prices and volatility, to the underlying financial health of the firm, thus providing a clear relationship between the condition of a balance sheet and the risk of default. Understanding these dynamics is crucial for practitioners and analysts because it helps in making informed decisions regarding credit risk and investment strategies.