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FRM Part II · FRM Exam Part II · Portfolio Credit Risk

A bank compares the Merton model's theoretical default probability with the KMV approach. Which feature best distinguishes KMV's EDF from the Merton model's default probability?

KMV maps the distance to default to an expected default frequency using an empirical database of historical default experience, rather than the normal distribution used in the pure Merton model, which better captures real-world default behaviour.

  1. AKMV maps distance to default to an expected default frequency using an empirical database of historical defaults rather than the normal distributionCorrect
  2. BKMV assumes the firm can default at any time before maturity only if equity is negative, using the normal distribution
  3. CKMV uses credit spreads on traded bonds as the sole input to estimate asset volatility
  4. DKMV assumes recovery is fixed at 100% of the debt face value

Explanation

KMV calculates distance to default similarly to Merton but converts it to an EDF using empirical default experience, which captures fat tails and non-normality. Using the normal CDF is the pure Merton step. KMV infers asset value and volatility from equity data, not bond spreads.

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