Free CAIA Level II Methods and Models Practice Questions
Methods and models on CAIA Level II covers structural credit risk models (Merton, KMV), reduced-form models, binomial tree valuation, factor models, principal component analysis (PCA), regression-based approaches, and relative value methodologies.
196 Questions
61 Easy
97 Medium
38 Hard
2026 Syllabus
Sample Questions
Question 1
Easy
In the KMV model, the distance to default (DD) is best described as:
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Correct Answer: A
Solution
A is correct. In the KMV model, distance to default measures how many standard deviations of asset value change separate the firm's current asset value from the default point (typically defined as short-term debt plus half of long-term debt). A larger DD implies a lower probability of default.
Question 2
Medium
The KMV model improves upon the original Merton model primarily by:
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Correct Answer: D
Solution
D is correct. A key innovation of KMV is the use of a large proprietary database of actual default histories to translate the theoretical distance to default into an empirical expected default frequency (EDF). This overcomes the Merton model's reliance on the normal distribution assumption for mapping DD to default probabilities.
Question 3
Hard
An analyst is comparing three credit modeling approaches for a large publicly traded corporation. Which of the following statements most accurately contrasts their strengths and limitations?
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Correct Answer: C
Solution
C is correct. Reduced-form models are highly flexible and can be calibrated to fit the observed term structure of credit spreads without requiring knowledge of firm asset dynamics. However, they treat default as an exogenous surprise and offer less economic intuition about what drives default compared to structural models. Empirical models like the Z-score are simple and historically well-validated but rely on financial statement data and may lag real-time market developments.
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