Structural model weaknesses

CFA Level II Fixed Income
#1

Question from 2016 mock exam:

Bauer replies, “There are numerous problems with estimating the structural model.” He provides three examples.

Problem 1: The structural model assumes that interest rates are constant over time.
Problem 2: The structural model requires estimating changes in asset return volatility related to the business cycle.
Problem 3: The structural model relies on accounting statement data, rather than market prices, and is therefore subject to being manipulated by the firm.

Which of the problems Bauer describes regarding estimation of the structural model of credit risk is most likely correct?

I answered Problem 3.

The correct is Problem 1
The structural model assumes that interest rates are constant over time, which is not true in practice and a particular problem for a model of debt value because debt is subject to substantial interest rate risk.

  • I didn’t see anywhere in the curriculum stating that the model assumes interest rates are constant over time and that this is a problem. Could someone point me out how to get into this conclusion?

  • Why is problem 3 not valid?

Thanks!

#2

The structural models assumes the company’s assets/liabilities are traded on the market which means that the assertion about accounting data is not entirely true.

#3

Yes, makes sense. Thanks!