Skip to content

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

Compared with the original Merton model, which feature is characteristic of the KMV approach to estimating expected default frequency (EDF)?

KMV converts distance to default into an expected default frequency using an empirical mapping from historical default data rather than the normal distribution, which better captures real-world default rates than the theoretical Merton probability.

  1. AIt maps distance to default to default probabilities using an empirical database of historical defaults rather than relying on the normal distributionCorrect
  2. BIt assumes default can only occur at debt maturity and uses a normal distribution to convert distance to default into probability
  3. CIt estimates default probability solely from credit spreads on traded bonds
  4. DIt assumes the firm's asset value is constant and default is driven only by the interest rate

Explanation

KMV computes distance to default from market asset value, asset volatility and a default point, then maps it to EDF using empirical default history, which handles fat tails and non-normality. The normal-distribution mapping at maturity is the pure Merton approach. Spreads-only and constant assets are not KMV features.

Did you get it right without looking?

One question tells you little. A timed set on Introduction to Credit Risk Modeling and Assessment shows your real accuracy, how long you take and where you lose marks.

Practise Introduction to Credit Risk Modeling and AssessmentFree diagnostic mock

More Introduction to Credit Risk Modeling and Assessment questions