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

A risk analyst applies the KMV approach to a corporate borrower. Which statement best describes how KMV obtains the expected default frequency (EDF) from the distance to default?

KMV converts the distance to default into an EDF using an empirical mapping based on historical default experience, rather than relying on the normal distribution. This corrects for non-normal asset returns and capital structure complexity in the pure Merton framework.

  1. AEDF is the normal cumulative probability of the negative distance to default in all cases
  2. BEDF is read from an empirical mapping of distance to default to historically observed default ratesCorrect
  3. CEDF is computed as the credit spread divided by one minus the recovery rate
  4. DEDF is set equal to the agency rating's average historical default rate

Explanation

KMV computes distance to default from asset value, asset volatility and default point, then maps it to an empirical default database to get EDF, because actual asset distributions have fat tails and the normal assumption would be inaccurate. Spread over loss given default is a reduced-form shortcut, not KMV.

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