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1. Merton Model (50 Points)

Consider a company with equity value equal to $80, and face value of debt of $50. The annual
log-return on risk-free debt is 3%. If the debt of the company expires in 0.5 years, how does the
probability of default of the company change as a function of the volatility of the equity?
a) Create a plot where the distance to default is on the y-axis and the volatility of the
equity (from 0.1 to 1.5, in increments of 0.1) is on the x-axis (20 Points).
b) Create a plot where the probability of default is on the y-axis and the volatility of the
equity (from 0.1 to 1.5, in increments of 0.1) is on the x-axis (20 Points).
c) Comment on the results (10 Points).