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

A bank uses a KMV-type (Moody's KMV Portfolio Manager) approach to estimating default probabilities. A firm has asset value of 140, default point of 100, and annual asset volatility of 10. Under the distance-to-default approach, ignoring drift, what is the distance to default and what does a larger value imply?

The distance to default is 4.0, calculated as 140 minus 100 divided by volatility of 10. A larger distance to default means the asset value is further from the default point, so the probability of default is lower.

  1. ADD = 4.0; lower probability of defaultCorrect
  2. BDD = 0.4; lower probability of default
  3. CDD = 4.0; higher probability of default
  4. DDD = 0.29; higher probability of default

Explanation

DD = (asset value - default point)/asset volatility = (140-100)/10 = 4.0 standard deviations. A larger distance means assets must fall further before default, so default probability is lower. Using 40/140 gives 0.29, which is the wrong base.

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