J
James789
Member
I have been looking at September 2015 Q3. Part (i) on CDS seems fine, however there seem to be some pretty big issues with the rest of the question in both the exam paper and the examiners' report.
Namely, the formula seems to assume one can substitute the continuously compounded risk free rate with the real world drift in the Merton model analysis. If mu as written in the question is the risk-free rate the formula correctly gives the risk neutral default probability. However, one can't motivate simply replacing this with the real world drift to obtain a real world default probability, which is what the question (and solution) seems to implicitly assume.
Also:
Even if one could do this, the solution says mu is the 'expected annual return on the firm's assets', when in fact is is related to the log-return.
The solution says that sigma is between 0 and 1, but there is no reason for an upper limit on sigma.
The examiners' report refers to the core reading - did the core reading back in 2015 contain formulae and discussion for such a 'real world' option price analysis, or is this just a really bad question? Would you get marks for giving what appears to be the actual correct explanation?
Namely, the formula seems to assume one can substitute the continuously compounded risk free rate with the real world drift in the Merton model analysis. If mu as written in the question is the risk-free rate the formula correctly gives the risk neutral default probability. However, one can't motivate simply replacing this with the real world drift to obtain a real world default probability, which is what the question (and solution) seems to implicitly assume.
Also:
Even if one could do this, the solution says mu is the 'expected annual return on the firm's assets', when in fact is is related to the log-return.
The solution says that sigma is between 0 and 1, but there is no reason for an upper limit on sigma.
The examiners' report refers to the core reading - did the core reading back in 2015 contain formulae and discussion for such a 'real world' option price analysis, or is this just a really bad question? Would you get marks for giving what appears to be the actual correct explanation?