Suppose That the Asset Value of a Firm Evolves According

question 1

Multiple Choice

Suppose that the asset value of a firm evolves according to a lognormal diffusion,as in Merton (1974) .The current value of the firm's assets is $100 million,and its volatility is 24.24%.Suppose too that the firm has only one issue of debt outstanding: zero-coupon debt with a maturity of three years,and a face value of $70 million.Finally,suppose that the risk-free rate of interest is 4% (continuously-compounded terms) for all maturities.What is the risk-neutral probability of the firm defaulting at maturity of the debt?

• A)17.12%
• B)19.23%
• C)20.02%
• D)21.22%

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Definitions:

Gut Feelings

Intuitive judgments and responses that one cannot articulately rationalize, often based on experience.

Intuition

The capacity to grasp concepts intuitively, without relying on deliberate thought.

Rapidly Formed

Quickly developed or put together, often with little preparation or forethought.

Representativeness Heuristic

A cognitive shortcut that involves making decisions based on how closely new information resembles existing stereotypes or prototypes.