Free CAIA Level II Methods and Models Practice Questions
Methods and models on CAIA Level II covers structural credit risk models (Merton, KMV), reduced-form models, binomial tree valuation, factor models, principal component analysis (PCA), regression-based approaches, and relative value methodologies.
In the KMV model, the distance to default (DD) is best described as:
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Correct Answer: D
Solution
D is correct. In the KMV model, distance to default measures how many standard deviations of asset value change separate the firm's current asset value from the default point (typically defined as short-term debt plus half of long-term debt). A larger DD implies a lower probability of default.
Question 2
Medium
The KMV model improves upon the original Merton model primarily by:
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Correct Answer: C
Solution
C is correct. A key innovation of KMV is the use of a large proprietary database of actual default histories to translate the theoretical distance to default into an empirical expected default frequency (EDF). This overcomes the Merton model's reliance on the normal distribution assumption for mapping DD to default probabilities.
Question 3
Hard
Which of the following statements most accurately describes a property of credit spreads generated by Merton's structural model?
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Correct Answer: D
Solution
D is correct. Under Merton, a highly leveraged firm has elevated near-term default probabilities, but conditional on surviving the early years the positive drift in asset value lowers later-period default probabilities, producing a humped (rising-then-falling) spread curve. Low-leverage firms instead produce an upward-sloping curve.
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