Credit Analysis L2

### Section: Credit Analysis — Fixed Income Estimated study time: 60 minutes Content: Exam weight (2026 curriculum): Fixed Income — 10–15% of the CFA Level II exam (one of four topics at the 10–15% band). Source: CFA Institute Level II Exam page, fetched 2026-06-29. At Level II, Fixed Income deepens beyond basic bond pricing into credit risk models (Merton, reduced-form), term structure, and mortgage-backed securities — each subject to vignette testing. Credit analysis at CFA Level 2 moves beyond issuer-level ratings to quantitative credit risk modeling and the pricing of credit risk in bonds and loans. Credit risk has two components: default risk (the probability the issuer fails to make promised payments) and loss severity (the fraction of principal lost given default, i.e., 1 minus the recovery rate). Expected loss = Probability of Default (PD) * Loss Given Default (LGD) = PD * (1 - Recovery Rate). Credit spreads in bond markets compensate investors for expected losses plus a credit risk premium for bearing uncertainty about credit losses. The credit spread on a corporate bond represents the additional yield above the comparable risk-free rate required by investors. The structural model of credit risk (Merton model) treats equity as a call option on the firm's assets. Equity holders receive the firm's asset value minus debt face value at maturity if assets exceed debt, or zero if assets fall below debt (in which case debt holders receive whatever assets remain). Formally: Equity = Max(V_A - D, 0) and Debt = V_A - Max(V_A - D, 0) = Min(V_A, D), where V_A is…