You are on page 1of 3

Forecast default risk of the corporate bonds

using KMV model
The objective of the project is to estimate the corporate bond default
using the KMV model and assign the rating based on its probability to
default. Moody’s KMV model has shown that the distance-to-default does
a good job in predicting corporate defaults.
Calculate the ‘distance to default’ (DD)
A key concept underlying the KMV approach is the recognition that a firm
does not have to default the moment its asset value falls below the face
value of debt – in fact default happens when value of the firm’s assets
falls somewhere between the value of the short term debt and the value
of the total debt. In other words, it is possible to not have default even if
the value of the assets has fallen to less than the total debt. This is
natural because it is generally the current cash needs (driven by short
term debt) that cause default – the firm may have enough cash to keep
paying all liabilities as they come due even though the total liabilities may
be greater than the total assets.
KMV sets the default point as somewhere between short term debt (STD)
and the total debt as the total of the short term debt and half the value of
the long term debt.

Next, the KMV approach determines what the ‘distance-to-default’ is. The
distance to default is the number of standard deviations assets have to
lose before getting to the default point (DPT). It is calculated as follows:

Where σ is the standard deviation of future asset returns. Each of the
terms in the equation above are explained below:

where μ and σ are the mean and volatility of the asset returns.com/products/content/debt/corp_bonds/cbm_reportin g_homepage.nseindia.This can be expressed another way – as a multiple of the standard deviation of the expected returns. The data is available in the NSE India website (http://www. Sampling Frame The sampling frame is the corporate bonds traded in the exchange in India.htm) Snapshot the data .

This is a limitation of the KMV model as the above scenario affects the volatility of the assets and hence in calculating the Distance to Default.Market-Based Estimation of Default Probabilities and Its Application to Financial Market Surveillance by Jorge A. In case there is bull spread and company is performing badly.riskprep. IMF Working Paper .Limitations of the project The volatility of corporate bonds depends on the company performance and market volatility. References 1.com/all-tutorials/37-exam-31/127-the-kmvapproach-to-measuring-credit-risk 2. https://www. the bonds of the company will still be traded well in the market. ChanLau .