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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A KMV-style analysis finds a firm with distance to default of 2.0. Under the pure Merton normal-distribution assumption, the risk-neutral-free (real-world) default probability is N(-2.0)=2.28%. Historical default data for firms at this distance to default show an actual default frequency of 6%. What is the best interpretation of the KMV approach to this discrepancy?

KMV maps distance to default to an empirical expected default frequency using a historical default database, rather than using the normal distribution. This corrects for non-normality and fat tails that cause the theoretical probability of 2.28% to understate the observed 6%.

  1. AThe model is invalid and should be replaced by a reduced-form model
  2. BKMV maps distance to default to an empirical expected default frequency using historical default data rather than relying on the normal distributionCorrect
  3. CKMV adjusts the distance to default by the risk-free rate before applying the normal distribution
  4. DKMV sets the default point equal to total liabilities, which removes the discrepancy

Explanation

KMV's key practical step is an empirical mapping from distance to default to an expected default frequency (EDF) from a historical database, addressing fat tails and non-normal asset distributions. Option C is wrong since drift is not the fix, and the default point (short-term debt plus half of long-term debt) is not total liabilities.

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