___ ___refers to an economic process in which undesirable outcomes occur when parties to a transaction have asymmetric information.

**Adverse selection **refers to an economic process in which undesirable outcomes occur when parties to a transaction have asymmetric information.

___ ___occurs after an economic transaction is completed and arises when one party to a transaction changes its behavior and the other party bears the consequences.

**Moral hazard **occurs after an economic transaction is completed and arises when one party to a transaction changes its behavior and the other party bears the consequences.

Recovery Rate Equation

PV of sum to be recovered / Exposure at Default (EAD)

Loss Given Default (LGD) Equation

Exposure at Default (1 - Recovery Rate)

Expected loss given credit risk equation

Loss Given Default (LGD) x Probability of Default (PD)

=

Exposure at Default (EAD) * (1 - Recovery Rate) * PD

The ___ approach to modeling credit risk assumes an explicit relationship between a firm's capital structure and default, and describes the value of a firm's assets as being equal to the value of its equity plus the value of its debt.

The **structural **approach to modeling credit risk assumes an explicit relationship between a firm's capital structure and default, and describes the value of a firm's assets as being equal to the value of its equity plus the value of its debt.

Under the structural approach, the firm's equity is considered a ___ ___on its assets, with a strike price equal the face value of its ___due at ___date.

Under the structural approach, the firm's equity is considered a **call option** on its assets, with a strike price equal the face value of its **debt **due at **exercise **date.

The ___-___approach to modeling credit risk models default as an exogenous event driven by a random signal.

The **reduced**-**form **approach to modeling credit risk models default as an exogenous event driven by a random signal.

The ___ approach to modeling credit risk involves examining the financial data of companies that have defaulted to try and understand their credit risk.

The **empirical **approach to modeling credit risk involves examining the financial data of companies that have defaulted to try and understand their credit risk.

The best known structural credit risk model is the ___ model.

The best known structural credit risk model is the **Merton **model.

Murton Model Equation

Assets = Debt + Equity

The Murton Model assumes that default occurs at ___. It also assumes that ___is costless, ___and ___can be traded without friction and that debt is a ___-___bond.

The Murton Model assumes that default occurs at **maturity**. It also assumes that **bankruptcy **is costless, **debt **and **equity **can be traded without friction and that debt is a **zero**-**coupon **bond.

Equity in a merton model equation

E = max(A - K, 0)

E = Equity

A = Assets

K = Strike

Debt in a merton model equation

D = K - max(K - A, 0)

D = Debt

K = Strike

A = Assets

Black-Scholes Option Pricing Model

d = what in black scholes model

Probability of Default in the Merton Model Equation

Value of Zero Coupon Debt in Merton Model (equation)

Spread in Merton Model (Equation)

The primary advantage of the ___ model is that it has several intuitive properties and serves as a basis for more complex models.

The primary advantage of the **Merton **model is that it has several intuitive properties and serves as a basis for more complex models.

The Merton model has several shortcomings:

1. It's model's parameters are not ___ ___

2. It is not successful as explaining the ___ ___ on ___-___ securities

The Merton model has several shortcomings:

1. It's model's parameters are not **readily observable**

2. It is not successful as explaining the **credit spread **on **short**-**term **securities

The Merton model has four important properties:

1. Sensitivity to ___

2. Sensitivity to ___ ___

3. Sensitivity to ___

4. Sensitivity to ___ ___

The Merton model has four important properties:

1. Sensitivity to **maturity**

2. Sensitivity to **asset volatility**

3. Sensitivity to **leverage**

4. Sensitivity to **riskless rate**

As time to maturity increases, the credit spread ___ initially, but then ___slightly.

As time to maturity increases, the credit spread **increases **initially, but then **declines **slightly.

As asset volatility increase, the probability of default ___ and the credit spread ___.

As asset volatility increase, the probability of default **increases **and the credit spread **increases.**

As leverage increases, the default probability ___ and the credit spread ___.

As leverage increases, the default probability **increases **and the credit spread **increases**.

The ___ model is a structural credit risk model that estimates the credit risk of debt by considering the loan repayment incentive problem from the perspective of the borrowing firm's equity holders.

The **KMV **model is a structural credit risk model that estimates the credit risk of debt by considering the loan repayment incentive problem from the perspective of the borrowing firm's equity holders.

The structural relationship between the MV of a firm's equity and its assets under the KMV model (Equation)

Relationship between volatility a firm's assets and equity according to KMV model (equation)

The ___ model's default trigger is the face value of the zero coupon bond.

The **merton **model's default trigger is the face value of the zero coupon bond.

The ___ model's default trigger is based on a weighted average of face values of short-term and long-term debt.

The **KMV **model's default trigger is based on a weighted average of face values of short-term and long-term debt.