Distance to Default

[hawayi_vgo]

40.1 Assume Stulz’ hypothetical firm Pure Gold will sell one million ounces of gold at the end the year, then will liquidate. The one-year forward price of gold is $1,200 per ounce and the gold price risk is UNSYSTEMATIC but has (normally distributed) volatility of 20%. The riskfree rate is 4.0%. The firm has one class of debt with face value of $805 million. Per the Merton model (i.e., default threshold equals debt face value), if the firm value drops below face value of the debt, Pure Gold will go bankrupt, and if it occurs, the cost of bankruptcy will be $50 million. What is the present value (PV) of bankruptcy costs (note: Stulz assumes annual compound frequency)?

Hi,

wonder if someone could explain to me distance to default....how we get 1.65 for dtd and how it converts to 5%? Couldn't find anything about it on the foundation study note...

Thank you!

is this a Part 1 Frm question?
Can someone explain to me

 

[ShaktiRathore]

Lognormal price-based DD = [V(t) - Default]/[sigma*V(t)] =[$1,200- $805]/ 20%=395/20%*1200=1.645
PD = N(-DD)=N(-1.645)=5%

please to understand more go to the link:
http://forum.bionicturtle.com/threads/merton-model-a-summary-of-the-issues.5646/
thanks

 

[southeuro]

Is this FRM level 1 type of question?

 

[David Harper CFA FRM]

Hi southeuro, yes, in my opinion, although this technically is sourced from a discontinued Stulz reading, this is plainly (easily) within P1. While it references Merton model for Credit risk, which is a P2 topic, that is incidental: it is asking about the application of a normal distribution (Shakti helpfully references my Merton post where it's true the values are lognormal, but this question never enters lognormal: "the gold price risk is UNSYSTEMATIC but has (normally distributed) volatility of 20%." Thanks,

 

[Aves Ahmed Khan]

Hi David Harper,
I am new here, I don't have background knowledge of DD but for some project I need to learn it. Would you please provide some Basic information about its concept and methods of calculating it. I will be very thankful to you.

 

[ShaktiRathore]

visit here,http://forum.bionicturtle.com/threads/merton-model-a-summary-of-the-issues.5646/
thanks

 

[David Harper CFA FRM]

Thanks ShaktiRathore you are too generous, I was just going to link to the same, thanks so much for the help