FRM II-CR 3

anbu.edu
Finance Junkie
Posts: 205
Joined: Mon Feb 04, 2013 3:35 pm

FRM II-CR 3

Postby anbu.edu » Wed Oct 15, 2014 6:05 pm

In the Merton model, with only debt and equity in the capital structure, the value of debt will decrease and the
value of equity will increase if the:
I. interest rate increases.
II. volatility of firm value increases.
III. value of the firm increases.
IV. value of the firm decreases.
A) II and III.
B) I, II, and IV.
C) I only.
D) I and II.
Your answer: B was incorrect. The correct answer was D) I and II.
Statements I and II are true. An increase in interest rates or volatility would increase the value of equity because
equity is valued as a call option. Since the value of the firm is assumed to be constant the value of debt must
decrease. Statements III and IV are incorrect because of the direct relationship between both equity and debt values and firm value.
Can you explain little more clearly why 3 & 4 is incorrect.. also what is the impact on value of debt regarding 3&4

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

FRM II-CR 3

Postby edupristine » Fri Oct 17, 2014 5:18 am

In the Merton model, the value of the equity is directly related to the value of firm. Interest rate and volatility of the firm are directly related to the value of equity. So, if the interest rates and volatility of the firm value increases, the equity value will increase. Correspondingly, debt value would decrease to keep the firm value constant. Therefore statements I &II are correct.

However, if the value of firm increases or decreases, we can't estimate with certainty if the value of debt/equity has increased/decreased. Hence statements III & IV are incorrect.

anbu.edu
Finance Junkie
Posts: 205
Joined: Mon Feb 04, 2013 3:35 pm

Postby anbu.edu » Fri Oct 17, 2014 10:11 am

Great explaination

anbu.edu
Finance Junkie
Posts: 205
Joined: Mon Feb 04, 2013 3:35 pm

Postby anbu.edu » Sat Oct 18, 2014 1:46 pm

In the Merton model, with only debt and equity in the capital structure, the value of debt will increase in value if
the:
I. interest rate declines.
II. volatility of firm value increases.
III. value of the firm increases.
IV. volatility of firm value decreases.
A) I only.
B) I, III, and IV only.
C) III and IV only.
D) I and II only.
Your answer: B was correct!
Statements I, III, and IV are correct. In the Merton model, the value of debt is directly related to the value of the
firm and the principal amount. Time to maturity of the debt claim, interest rate, and the volatility of the firm are all
inversely related to the value of debt.

This is a similar question but the answer is different.. Can you please explain why 3 is correct answer


Return to “FRM Part II”



Disclaimer

Global Association of Risk Professionals, Inc. (GARP®) does not endorse, promote, review or warrant the accuracy of the products or services offered by EduPristine for FRM® related information, nor does it endorse any pass rates claimed by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to EduPristine nor is GARP® responsible for any fees or costs of any person or entity providing any services to EduPristine Study Program. FRM®, GARP® and Global Association of Risk Professionals®, are trademarks owned by the Global Association of Risk Professionals, Inc

CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by EduPristine. CFA Institute, CFA®, Claritas® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

Utmost care has been taken to ensure that there is no copyright violation or infringement in any of our content. Still, in case you feel that there is any copyright violation of any kind please send a mail to abuse@edupristine.com and we will rectify it.