Scribd Logo
Upload

Welcome to Scribd!

  • 223 views

    KMV Model

    Uploaded by

    Vijay Behra
    The KMV model calculates the Expected Default Frequency (EDF) based on a firm's capital structure, asset value volatility, and current asset value. It proceeds in 3 stages: 1) Estimating asset value and volatility through an options model. 2) Calculating distance-to-default as standard deviations between asset value and default point. 3) Deriving default probabilities by mapping distance-to-default to EDF. Variations in stock price, leverage, and asset volatility can change a firm's EDF.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOC, PDF, TXT or read online from Scribd

    KMV Model

    Uploaded by

    Vijay Behra
    223 views5 pages
    The KMV model calculates the Expected Default Frequency (EDF) based on a firm's capital structure, asset value volatility, and current asset value. It proceeds in 3 stages: 1) Estimating asset value and volatility through an options model. 2) Calculating distance-to-default as standard deviations between asset value and default point. 3) Deriving default probabilities by mapping distance-to-default to EDF. Variations in stock price, leverage, and asset volatility can change a firm's EDF.

    Original Title

    KMV model

    Copyright

    © Attribution Non-Commercial (BY-NC)

    Available Formats

    DOC, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    The KMV model calculates the Expected Default Frequency (EDF) based on a firm's capital structure, asset value volatility, and current asset value. It proceeds in 3 stages: 1) Estimating asset value and volatility through an options model. 2) Calculating distance-to-default as standard deviations between asset value and default point. 3) Deriving default probabilities by mapping distance-to-default to EDF. Variations in stock price, leverage, and asset volatility can change a firm's EDF.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    223 views5 pages

    KMV Model

    Uploaded by

    Vijay Behra
    The KMV model calculates the Expected Default Frequency (EDF) based on a firm's capital structure, asset value volatility, and current asset value. It proceeds in 3 stages: 1) Estimating asset value and volatility through an options model. 2) Calculating distance-to-default as standard deviations between asset value and default point. 3) Deriving default probabilities by mapping distance-to-default to EDF. Variations in stock price, leverage, and asset volatility can change a firm's EDF.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    of 5

    The KMV model

    KMV is a trademark of KMV Corporation that was founded in 1989. The


    KMV model calculates the Expected Default Frequency (EDF) based on
    the firm’s capital structure, the volatility of the assets returns and the
    current asset value. This model best applies to publicly traded
    companies for which the value of equity is market determined.

    The translation of the public information into probabilities of default


    proceeds in 3 stages:

    1st Stage: Estimation of the asset value and the


    volatility of asset return

    Financial models usually consider market values of assets, and not


    book values which only represent historical costs of the physical
    assets, net of their depreciation. The calculation of the market value of
    the firm’s assets and their volatility would be simple if all the liabilities
    of the firm were traded and market-to-market every day.

    Alternatively, KMV use the option pricing model to the valuation of


    corporate liabilities as proposed in “On the pricing of corporate debt:
    The risk structure of interest rates (Merton, R., 1974 in Journal of
    Finance 28, 449-470)”. According to this model, we assume that the
    firm’s capital structure is composed of equity, short-term debt which is
    considered equivalent to cash, long-term debt which is assumed to be
    a perpetuity, and convertible preferred shares.
    The estimation of the asset value and volatility of asset return usually
    requires the implementation of iterative techinique, with no analytical
    solution.

    2nd Stage: Calculation of the distance-to-default

    According to KMV, the default occurs when the asset value reaches a
    level somewhere between the value of total liabilities and the value of
    short-term debt. This point is named default point (DPT), and it is
    considered by KMV as the short-term debt plus half the long-term debt.
    The distance-to-default (DD) is the number of standard deviations
    between the mean of the distribuition of the assets value and the
    default point (DPT).

    Fig. 3: Distance-to-Default

    Source: Jornal of Banking & Finance (2000)


    E (V1) = expected asset value in 1 year
    DPT = (short-term debt) + 1/2 (long-term debt)
    S= volatility of asset returns

    3rd Stage: Derivation of the probabilities of default

    The last stage consists as mapping the DD to the Expected Default


    Frequency (EDF), for a given time horizon. Using a large sample of
    firms, we can draw the EFD as a function of the DD, as following:

    Once we have the EDF for a given obligor, KMV uses a risk neutral
    valuation model to derive prices as a discounted expected value of
    future cash flows. The valuation of risky cash flows consists of (1) the
    valuation of the default-free component and (2) the valuation of the
    component exposed to credit risk:
    PV = Present Value of the cash flow
    FV = Future Value (the obligation)
    LGD = Loss Given Default, in percent
    1 – LGD = recovery rate
    i = the 1-year risk-free rate
    Q = probability that the issuer defaults in 1 year, which is derived from
    EDF

    Conclusion

    Variations in the stock price, the leverage ratio, and the asset volatility
    can all change the firm’s EDF. Higher volatility of asset return implies
    that the market has more uncertainty on the fim’s business value. To
    calculate the CreditVaR, KMV defines the portfolio loss as the
    difference between risk less value of the portfolio and its market value.

    As we have exposed, KMV’s methodology relies almost exclusively on


    equity market information. We therefore can not implement KMV
    model where the stock prices do not represent the real value of the
    companies.

    You might also like