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FRM Part II · FRM Exam Part II · Credit Value at Risk

A risk analyst compares the KMV approach with the basic Merton model for estimating default probabilities. Which statement about KMV is correct?

KMV converts distance to default into an expected default frequency using an empirical mapping from historical default data, rather than relying on the normal distribution. Its default point is short-term debt plus part of long-term debt, not total liabilities.

  1. AIt sets the default point equal to total liabilities and uses the normal distribution to convert distance to default into a probability
  2. BIt maps distance to default to an expected default frequency using an empirical database of historical defaultsCorrect
  3. CIt assumes default can occur only at debt maturity, as in the original Merton model
  4. DIt estimates asset volatility directly from observed bond spreads without using equity data

Explanation

KMV computes distance to default using a default point (short-term debt plus a portion of long-term debt) and maps it to EDF using empirical default experience, not the normal distribution. Total liabilities as the default point is wrong. Asset value and volatility are inferred from equity data.

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