What does PD represent in the Merton Model?

In the Merton Model, PD stands for Probability of Default. This model, which is grounded in option pricing theory, quantifies the likelihood that a borrower will fail to meet its debt obligations. It evaluates the credit risk associated with a company by modeling its assets as options on its liabilities.

In this context, the Probability of Default signifies the chance that the value of a firm's assets will fall below a certain threshold (the value of its liabilities) by the time those liabilities are due. This is critical for risk managers and analysts as understanding the PD helps in assessing the credit risk of borrowers and constructing risk-sensitive portfolios. By assigning a probability to the likelihood of default, financial institutions can better manage their capital reserves and pricing strategies on loans and credit products.

The other choices do not accurately capture the concept represented by PD in this model. Therefore, recognizing this interpretation is essential for anyone studying the Merton Model and its applications in financial risk management.