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

In the KMV implementation of the Merton framework, which default point is conventionally used when computing distance to default?

KMV uses short-term debt plus one-half of long-term debt as the default point. Empirically, firms tend to default when asset value falls to a level between short-term liabilities and total liabilities, so this intermediate threshold is used.

  1. ATotal liabilities
  2. BLong-term debt only
  3. CShort-term debt plus one-half of long-term debtCorrect
  4. DMarket value of equity

Explanation

KMV observed that firms typically default when asset value falls between total liabilities and short-term debt, and uses short-term liabilities plus half of long-term liabilities as the default point. Total liabilities is too high and equity value is not a debt-based barrier.

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