Implications of Reduced Form Models for Bond Valuation

Medium Credit Analysis And Valuation Reduced Form Models

ABC Corporation is considering a new bond issuance and is evaluating the default risk associated with its bonds using a reduced form model. The model suggests that the arrival of information regarding the firm's creditworthiness can be modeled as a Poisson process. The firm estimates a constant default intensity of 2% per year.

Given this information, which of the following statements is accurate regarding the implications of using a reduced form model to value the firm's bonds?

Reduced form models assume that default events occur randomly over time and the timing of defaults follows a predictable pattern.

The reduced form model's assumption of constant default intensity implies that the probability of default remains constant over time.

In reduced form models, the predicted bond yield spreads are only influenced by systematic risk factors.

Hint

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