Measuring & Managing Credit RiskEDF™ Credit Measures for Public Firms
October 2006
2 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Session Objectives
1. What is the EDF credit measure?
2. When does a firm Default?
3. What drives the EDF credit measure?
4. How are the EDF Drivers calculated?
5. How is the EDF measure calculated from the EDF Drivers?
6. EDF methodology summary
7. EDF validation
8. Conclusion
1 2 3 4 5 6 7 8
3 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
EDF Credit Measure for Public Firms
EDF stands for Expected Default Frequency – the probability that a firm will
default within a given time horizon by failing to make an interest or principal
payment.
We provide EDF measures for time horizons of 1, 2, 3, 4, and 5 years.
EDF Ranges from .02% to 20%, i.e., 2 to 2000 basis points.
Say we create a portfolio of 100 firms, each with a 2% EDF. On average, 2
out of the 100 firms will default over the next year, and 98 will not default.
A firm with a 2% EDF is 10 times more likely to default than a firm with a
0.2% EDF.
1 2 3 4 5 6 7 8
4 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
.02
.05
.10
.15 .20
.50
1
2
5 7 10
15 20
Aaa
Aa
A
Baa
Ba
B
Caa Ca C
AAA
AA
A
BBB
BB
B
CCC CC
06/00 11/00 05/01 11/01 05/02 11/02 05/03 11/03 05/04 11/04 05/05
N-COLLINS & AIKMAN CORP-EDF N-COLLINS & AIKMAN CORP-S&P
1-Year EDF
S&P Rating
Source: Credit Monitor
Default Example: Collins & Aikman Corp
1-Year EDF S&P Rating
DefaultedMay 2005
1 2 3 4 5 6 7 8
The value of EDF: Measures credit risk in terms of absolute default probabilities rather than relative rankings.
Provides the most accurate forward-looking, causal model.
Provides frequent updates and early warning of changes in credit quality.
5 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Agency Ratings: An Example
1 2 3 4 5 6 7 8
6 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Agency Ratings: Another Example
1 2 3 4 5 6 7 8
7 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Differentiating EDF Credit Measures from Traditional Ratings
EDF Credit Measures Objective, Market driven Quantitative Method
Quantitative Output
EDF = 0.02% (An actual probability of default)
Absolute (Cardinal) Precise and continuous, providing full
granularity (high resolution) Specific time horizon Reflects current assessment of future
prospects of the firm/economy Dynamic, updated daily or monthly Reflects issuer’s default probability
(PD), and not issue-specific LGD
Traditional Ratings Subjective, driven by fundamental analysis Qualitative Method
Qualitative Output
AAA = “Obligor’s capacity to meet its financial commitment on the obligation is extremely strong.”
Relative (Ordinal) Distinct risk buckets without specifying or
targeting a specific default rate No specific time horizon (“long term”) Supposed to reflect average economic
conditions – “through the cycle” Stable (low ratings volatility) Opinion on Expected Loss – combines the
effect of PD and LGD (Loss Given Default)1 2 3 4 5 6 7 8
8 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
.02
.05
.10
.15 .20
.50
1
2
5 7 10
15 20
Aaa
Aa
A
Baa
Ba
B
Caa Ca C
AAA
AA
A
BBB
BB
B
CCC CC
06/00 11/00 05/01 11/01 05/02 11/02 05/03 11/03 05/04 11/04 05/05
N-TROPICAL SPORTSWEAR INTL CP-EDF
N-TROPICAL SPORTSWEAR INTL CP-S&P
Default Example: Tropical Sportswear intl.
1-Year EDF
DefaultedDecember 2004
S&P Rating
Source: Credit Monitor
1-Year EDF
S&P Rating
1 2 3 4 5 6 7 8
9 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
When does a firm Default?
A firm defaults when the value of its business falls below what it owes.
If the firm value is greater than what it owes, the equity holders have the ability and incentive to pay the debt obligations and keep the firm alive.
A firm’s ability to pay its debt depends more on the Market Value of its Assets, and less on its cash position.
If the assets of the firm have sufficient market value, the firm can raise cash by selling a portion of its assets - or by issuing additional equity or debt.
EDF is the probability that a firm’s future market value will be insufficient to meet its future debt obligations.
1 2 3 4 5 6 7 8
10 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
100
150
200
250
300
350
400
06/00 11/00 05/01 11/01 05/02 11/02 05/03 11/03 05/04 11/04 05/05
N-TROPICAL SPORTSWEAR INTL CP-AVL N-TROPICAL SPORTSWEAR INTL CP-DPT
Source: Credit Monitor
Market Value of Assets
Default Point(Liabilities Due)
Default Example: Tropical Sportswear Intl.
DefaultedDecember 2004
DefaultedDecember 2004
• EDF at T1 is greater than EDF at T2.
• Higher Leverage implies Higher EDF.
• Asset Value and Liabilities drive EDF.
• What else drives EDF?
T2
?
T1
?
Market Value of Assets Default Point
$ Million
1 2 3 4 5 6 7 8
11 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
20000
40000
60000
80000
100000
120000
140000
05/99 10/99 04/00 10/00 04/01 10/01 04/02 10/02 04/03 10/03 04/04
N-PEPSICO INC-AVL N-PEPSICO INC-DPT
N-DELL INC-AVL N-DELL INC-DPT
Does similar Leverage imply similar EDF?
Pepsi’s Market Value of Assets
Dell’s Market Value of Assets Pepsi’s Default Point
Dell’s Default Point
Pepsi’s Market Value of Assets
Dell’s Market Value of Assets
Dell’s Default Point Pepsi’s Default Point
February 2003: Dell and Pepsi had similar Market Leverage.
Did they have similar EDF?
$ MillionSource: Credit Monitor
12 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
.02
.05
.10
.15 .20
.50
1
2
5 7 10
15 20
Aaa
Aa
A
Baa
Ba
B
Caa Ca C
AAA
AA
A
BBB
BB
B
CCC CC
05/99 10/99 04/00 10/00 04/01 10/01 04/02 10/02 04/03 10/03 04/04
N-PEPSICO INC-EDF N-DELL INC-EDF
Pepsi’s EDF
Dell’s EDF
0.02
0.69
• Why is Dell’s EDF substantially higher?
• Asset Volatility: 46% (Dell) vs. 19% (Pepsi)
• Asset Volatility and Leverage drive EDF
Pepsi and Dell in Feb 2003: Similar Leverage but different EDF
Source: Credit Monitor
Pepsi’s EDF Dell’s EDF
13 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
EDF Drivers
1. Market Value of Assets (or Business Value)
Market assessment of the future cash flows of the business
Value of the firm as a “going concern”
2. Default Point (or Liabilities Due)
The liabilities due in the event of distress
3. Asset Volatility (or Business Risk)
The variability of the market value of assets
1 2 3 4 5 6 7 8
14 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
ssetValue
Value
EDF Drivers: A Pictorial ViewDistribution of Market Value of Assets at Horizon (1 Year)
EDF™
Expected Market Value of Assets
Asset olatility(1 Standard Deviation)
efault PointD
A
V
Today Time1 Year
Note: The symbol “~” stands for “increasing function of” or “directionally equivalent to”. 1 2 3 4 5 6 7 8
DA
VAsset olatility
efault Point ]log [ sset Value /EDF ~
15 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Impact of the EDF Drivers on EDF
Default Point goes up………………….….………….EDF goes
Market Value of Assets goes up……….……………EDF goes DOWN
Market Leverage (Default Point / Market Value of Assets) goes up………………………………………...….…...EDF goes
Asset Volatility goes up………….…..….……………EDF goes UP
UP
UP
DA
VAsset olatilityEDF is an increasing function of : efault Point ]log [ sset Value /
1 2 3 4 5 6 7 8
16 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Estimating Market Value of Assets
Market Value of Assets is the total market value of the firm as a “going concern.”
Market Value of Assets is the Net Present Value of the firm’s future cash flows.
Market Value of Assets is NOT the Book Value of Assets.
Market Value of Assets is NOT the Market Capitalization, which is equal to the Market Value of Equity.
Even though the Equity of a public firm is traded in the markets, the firm’s Assets are not traded. Market Value of Assets is not directly observable.
1 2 3 4 5 6 7 8
17 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Value
ValueAssets*
A firm derives value from the cash flows it is expected to generate.
For most firms, we cannot find
Market Value of Assets by adding
Market Value of Liabilities and
Equity as the total amount of
market value of liabilities is not
available (most debt is not traded).
Moreover, Market Value of liabilities
is not equal to the Book Value of
Liabilities, because the Market
Value of Liabilities changes with
credit quality.
Estimating Market Value of Assets: Capital Structure of a Firm
Liabilities*
Senior claim on the Assets.
Upside limited to principal and
interest.
Equity*Junior claim on
the Assets.Unlimited upside
and limited downside.
* Asset, Liability, and Equity depicted above are market values and not book values.
Claim
Future Cash Flowproduced by Assets
Claim
Liabilities and Equity represent a complete set of claims on the asset value.
1 2 3 4 5 6 7 8
18 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
What is the relationship between Equity and Market Value of Assets?
Equity holders have the right, but not the obligation, to “buy” the firm’s assets from the lender by re-paying the debt.
When the Market Value of Assets is above what is owed, Equity holders can exercise the above right. As the Asset Value increases beyond what is owed, Equity Value continues to increase: Unlimited upside.
When the Market Value of Assets is below what is owed, Equity holders can choose not to exercise the above right. As the Asset Value goes below what is owed, Equity Value approaches zero - but never goes negative: Limited downside (limited liability).
Key insight from Black, Scholes, and Merton (1973,74):
Equity is a Call Option on the firm’s Assets.
Derivative Pricing Theory (Black, Scholes, etc.) provides a mathematical relationship between Market Value of Assets (Underlying) and Equity Value (Derivative).
1 2 3 4 5 6 7 8
19 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Strike Price(Contractual Amount)
Underlying
Cal
l O
pti
on
Val
ue
Estimating Market Value of Assets: Equity as a Call Option on the Assets
Liabilities(Contractual Amount)
Market Value of
Assets
Eq
uit
y V
alu
eGeneric Call OptionEquity as a Call
Option on the firm’s Assets
Strike Price Liabilities
Underlying Market Value of Assets
Call Option Value Equity Value
1 2 3 4 5 6 7 8
20 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Equity as a Call Option on the Assets
Equity is a Call Option on the
Market Value of Assets.
Option Pricing Theory provides an
extensively validated relationship
between Equity Value and Market
Value of Assets.
Given an Equity Value, this
relationship can be used to solve
for the Market Value of Assets.
Liabilities(Contractual Amount)
Market Value of
Assets
Eq
uit
y V
alu
e
1 2 3 4 5 6 7 8
21 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
MKMV Public EDF Model: An Extension of the Merton Model
Merton MKMV Public EDF Model
Two classes of Liabilities: Short Term Liabilities and Common Stocks
Five Classes of Liabilities: Short Term and Long Term Liabilities, Common Stocks, Preferred Stocks, and Convertible Stocks
No Cash Payouts Cash Payouts: Coupons and Dividends (Common and Preferred)
Default occurs only at Horizon. Default can occur at or before Horizon.
Equity is a call option on Assets, expiring at the Maturity of the Short Term Liabilities.
Equity is a perpetual call option on Assets; it never expires.
1 2 3 4 5 6 7 8
22 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Default Point
The amount of Liabilities due in the event of distress
The threshold level of Market Value of Assets, below which the firm defaults
Default Point is a function of the firm’s Liability structure, as described by the balance sheet - specifically the short/long term breakdown of Liabilities.
MKMV empirical research: Default Point lies between the Short Term Liabilities and the Total Liabilities.
Default Point ≈ Short Term Liabilities + ½ of Long Term Liabilities
1 2 3 4 5 6 7 8
23 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
100
150
200
250
300
350
400
06/00 11/00 05/01 11/01 05/02 11/02 05/03 11/03 05/04 11/04 05/05
N-TROPICAL SPORTSWEAR INTL CP-AVL N-TROPICAL SPORTSWEAR INTL CP-LBS
N-TROPICAL SPORTSWEAR INTL CP-DPT
Default Point
Source: Credit Monitor
Market Value of Assets
Total LiabilitiesDefaulted
December 2004
DefaultedDecember 2004
Default Example: Tropical Sportswear Intl.
Market Value of Assets
Default Point
Total Liabilities
$ Million
24 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Asset Volatility
A measure of the variability in the firm’s future Market Value of Assets.
Reflects the degree of uncertainty in the firm’s future earnings.
Quantifies business risk: Firms in the same industry/country and of similar
size tend to have similar asset volatilities.
Neither the Market Value of Assets, nor the Asset Volatility is directly
observable. They can be implied from the Equity Value and Equity Volatility.
1 2 3 4 5 6 7 8
25 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Asset 100Liability 80
Equity 20
Estimating Asset Volatility and the Role of Leverage
+20 +20
5
Leverage
Change in Equity = +100% (20/20)Change in Asset Value = +20% (20/100)
Home originally worth:100Down Payment:20
Bank Loan:80Home now worth:120
De-Leverage
1/5Change in Asset Value = +20% (20/100) Change in Equity = +100% (20/20)
A measure of the variability in the firm’s future Market Value of Assets (business risk).
Measured as the standard deviation of the Annual % Change in the Market Value of
Assets. Example: Asset Volatility of 30% indicates that a typical change in the business
value is plus or minus 30% over the next year.
Volatility Volatility
1 2 3 4 5 6 7 8
26 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Asset Return Equity Return
Estimating Asset Volatility using the Options Framework
The same Options Framework that links Equity Value to the Market Value of Assets
also links Equity Volatility to Asset Volatility. Equity Returns are de-levered to obtain
Asset Returns.
Asset Returns are then used to calculate the Empirical Asset Volatility.
The Empirical Asset Volatility (historical) gains predictive power when blended with a
comparables-based (along size, profitability, country, industry) volatility measure
(Modeled Asset Volatility).
Empirical Asset Volatility
Modeled Asset VolatilityAsset Volatility
… … …
1 2 3 4 5 6 7 8
Standard Deviation
27 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Estimating Asset Volatility
Asset Volatility is NOT equal to Equity Volatility.
Leverage amplifies the Volatility of the underlying Assets to produce a higher Volatility at the Equity level.
The same Options Framework that links Equity Value to the Market Value of Assets also links Equity Volatility to Asset Volatility.
Equity Returns are de-levered to obtain Asset Returns, which are then used to calculate an historical Asset Volatility.
The historical Asset Volatility is combined with volatility information from comparable firms (of similar size, profitability, industry, country) to estimate each firm’s final Asset Volatility.
1 2 3 4 5 6 7 8
28 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
0%
5%
10%
15%
20%
25%
30%
35%
200 500 1,000 10,000 50,000 100,000 200,000
Total Assets ($m)
Ann
ualiz
ed V
olat
ility
COMPUTER SOFTWARE
AEROSPACE & DEFENSE
FOOD
UTILITIES, ELECTRIC
BANKS AND S&LS
Asset Volatility: Measure of Business Risk
1 2 3 4 5 6 7 8
29 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Time
Rising Equity Market Cap
Because of rising Asset Volatility
But a Dramatically Higher EDF
Asset Volatility: A Critical EDF Driver
30 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Calculating EDF from EDF Drivers and Distance to Default
Distance to Default (DD) ≈ The number of Standard Deviations the Market Value of Assets is away from Default Point
Why is the relationship between EDF and the three drivers defined as above?
Expected Default Frequency = Probability that the Market Value of Assets in 1 Year falls below
the Default Point.
= Solid Area under the Probability Curve. For example, N (-DD) is the Probability that a Standard
Normal Variable will be DD or farther below the mean.
(Normality was Merton’s assumption, but is not used by MKMV)
AssetValue
TodayTime
Value
EDF
1 Year
Expected Market Value of Assets
Asset Volatility(1 Standard Deviation)
Default Point
Asset VolatilityEDF ≈ Default Point
Market Value of AssetsX
1 2 3 4 5 6 7 8
31 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Calculating EDF from EDF Drivers and Distance to Default
Distance to Default (DD) ≈ The number of Standard Deviations the Market Value of Assets is away from Default Point
AssetValue
TodayTime
Value
EDF
1 Year
Expected Market Value of Assets
Asset Volatility(1 Standard Deviation)
Default Point
DD is the distance between the (log of) Market Value of Assets and Default Point,
expressed as a multiple of Asset Volatility.
EDF is an increasing function of 1/DD and a decreasing function of DD.
Distance to Default (DD) ≈ log [Market Value of Assets
Default point Asset Volatility
1] X
1 2 3 4 5 6 7 8
32 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Distance to Default (DD)
DD represents the cushion between Market Value of Assets and Default
Point, expressed as a multiple of Asset Volatility.
The Larger the DD, the Larger the cushion, and the Lower the EDF.
The Smaller the DD, the Smaller the cushion, and the Higher the EDF.
EDF moves inversely with DD.
It provides a relative rank ordering of Default Risk.
We must transform DD into EDF to get an absolute probability of default
1 2 3 4 5 6 7 8
33 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Transforming DD to EDF: Classic Merton Approach
The classic Merton approach uses Normality and other simplifying assumptions to
map DD to EDF, using a Cumulative Normal Distribution transformation:
Merton EDF = N(-DD), where N is the Cumulative Normal Distribution function.
EDFs calculated using the above approach (i.e., simplifying assumptions) dramatically
understate the default probability.
Example: Firms with DD = 4 are predicted to have a default rate of 0.003% under the
Normal distribution assumption. But, in reality, firms with DD = 4 are found to
have a default rate of 0.6%: 200 times that predicted by Normality assumptions!
Normality or other simplifying assumptions CANNOT be used in mapping DD to EDF.
1 2 3 4 5 6 7 8
34 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Realized PD
Assumptions vs. Reality: Firms tend to change Liabilities as they approach distress.
Firms tend to change (increase) Liabilities as they approach distress.
Reality
Merton PD
Liabilities are assumed to be stable over time.
Merton Model
Default Point
Increase in Liabilities can be proxied, say, by a higher Default Point, causing a higher PD.
Horizon
AssetValue
Time
AssetValue
1 2 3 4 5 6 7 8
35 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Assumptions vs. Reality: Default can happen anytime before Horizon.
Defaulting Path
Default occurs the first time Asset Value falls below Default Point.
Reality
Merton PD
Default Point
Non-Defaulting Path
?
Merton Model: Non-Defaulting PathReality: Defaulting Path
Realized PD
Default occurs when Asset Value at Horizon is below Default Point.
Merton Model
Horizon
AssetValue
AssetValue
Time
36 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Assumptions vs. Reality: Asset Return Distribution is Fat Tailed.
Asset Return Distribution is Fat Tailed.
Reality
Asset Return Distribution is Normal.
Merton Model
Merton PD
Realized PD
Default Point
Horizon
AssetValue
Time
AssetValue
37 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Modeling the Default Process is difficult. How do we overcome it?
We cannot use the Normal Distribution to map DD to EDF. Reasons include:
Firms change Liabilities as they approach distress; Default Point is not constant.
Default can happen anytime before Horizon; Default Point is an absorbing boundary.
Asset returns are fat-tailed relative to the Normal Distribution.
The default processes of actual firms are difficult to model analytically.
We overcome the above challenges by empirically mapping DD to EDF.
1 2 3 4 5 6 7 8
38 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Empirically mapping DD to EDF
DD is empirically mapped to EDF by tracking the default experience of thousands of firms from MKMV’s extensive Default Database.
MKMV uses actual default rates for companies in similar risk ranges (DD buckets) to determine a one-to-one relationship between DD and EDF.
Distance to Default
ED
F
1 2 3 4 5 6 7 8
39 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
MKMV Database
MKMV Public Firm Default Database (Global)1973-2005
(7,600 + defaults)
Def
aults
Quarter
1 2 3 4 5 6 7 8
40 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Empirically mapping DD to EDF
1 2 3 4 5 6 7 8
1) Search the Default Database for all
instances of firms having a DD of 6.
2) 42,000 such instances (of firms having a
DD of 6) were found.
3) 17 out of these 42,000 instances resulted
in Default in the next 1 year.
4) Empirical Default Rate corresponding to a
DD of 6 is 17/42000 = .04% = 4bp
5) Map DD of 6 to an EDF of .04% = 4bp
6) Repeat above steps for other DD buckets.
DD = 6
42,000 Instances of DD = 6
17 Defaults over the next 1 year
1-Year EDF™ =17 / 42,000 = 4bp
41 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Empirically mapping DD to EDF
DD =1
DD = 4
DD = 2
DD = 5
DD = 3
DD = 6
9000 Instances 15000 Instances 20,000 Instances
35000 Instances 40,000 Instances 42,000 Instances
720 Defaults 450 Defaults 200 Defaults
150 Defaults 28 Defaults 17 Defaults
EDF™ =800bp EDF™ =300bp EDF™ =100bp
EDF™ =43bp EDF™ =7bp EDF™ =4bp
1 2 3 4 5 6 7 8
42 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Distance to Default
ED
F
EDF = 0.43%
Calculating EDF using the DD to EDF Mapping
EDF = 20%
EDF = 0.02%
DD = 4
1 2 3 4 5 6 7 8
43 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
DD to EDF: One-to-One Relationship
Two firms with the same DD will have the same EDF - even if they differ with respect to Size, Industry, Geography, or the EDF Drivers.
Size, Industry, and Geography do affect Default Risk. The effects of Size, Industry, and Geography are already embedded in DD via the three EDF Drivers: Market Value of Assets, Asset Volatility, and Default Point.
Distance to Default
ED
F
1 2 3 4 5 6 7 8
44 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
EDF methodology summary
Asset VolatilityMarket Value
of AssetsDefault Point
Distance to Default
DD-EDF Mapping
EDF
Equity is a Call Option on the Assets.Solve for Market Value of Assets and
Asset Volatility.
Market Value of Equity
Amount of Short and Long Term Liabilities
Amount of Short/Long Term Liabilities determine Default Point
Distance to Default is the cushion between Market Value of Assets
and Default Point, expressed as a multiple of Asset Volatility.
MKMV’s Default Database is used to empirically map DD to EDF.
EDF is the probability that the firm will default within the specified time horizon.
1 2 3 4 5 6 7 8
45 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
1 Yr
AssetValue
1-YearEDF™
Expected Market Value of Assets
Today Time
Value
EDF Methodology: EDF for Horizon beyond 1 Year
2 Yrs
Distribution of Market Value of Assets at Year 1
1-YearDistance-to-Default
2-YearCumulative EDF
Distribution of Market Value of Assets at Year 2
1-YearAsset Volatility
1-Year Default Point
2-Year Default Point
2-YearAsset Volatility
2-YearDistance-to-Default
1 2 3 4 5 6 7 8
46 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
100
150
200
250
300
350
400
.02
.05
.10
.15 .20
.50
1
2
5 7 10
15 20
Aaa
Aa
A
Baa
Ba
B
Caa Ca C
AAA
AA
A
BBB
BB
B
CCC CC
06/00 11/00 05/01 11/01 05/02 11/02 05/03 11/03 05/04 11/04 05/05
TR
OP
ICA
L S
PO
RT.
..-A
VL
TR
OP
ICA
L S
PO
RT.
..-D
PT
TR
OP
ICA
L SP
OR
T...-ED
F T
RO
PIC
AL S
PO
RT...-A
SG
N-TROPICAL SPORTSWEAR INTL CP-AVL N-TROPICAL SPORTSWEAR INTL CP-DPT
N-TROPICAL SPORTSWEAR INTL CP-EDF N-TROPICAL SPORTSWEAR INTL CP-ASG
Tropical Sportswear Intl.: EDF along with the three EDF Drivers
1-Year EDFMarket Value of Assets
Default Point
Asset Volatility
DefaultedDecember 2004
Ass
et V
alu
e ($
Mil
lio
n),
D
efau
lt P
oin
t ($
Mil
lio
n)
ED
F (%
), Asset V
ola
tility (%)
Market Value of Assets
Asset Volatility
Default Point
EDF
47 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Early Warning Power of EDF Measures
Months Before and After Default
ED
F,
Rat
ing
MKMV EDFMoody’s Rating
Median EDF and Rating-Implied EDF for Defaulted FirmsUnited States Data: 1996-2004
• Median EDF tends to start rising 24 months before default.
• Median Rating tends to stay flat until a year before default, showing a steep rise about 4 months before default.
• EDF tends to lead the Ratings.
• EDF provides early warning power.
• EDF is dynamic and continuous, while Ratings move in discrete steps.
1 2 3 4 5 6 7 8
48 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Does the Predicted Default Rate (EDF) match the Actual Default Rate?
Predicted and Actual Number of DefaultsUS Public Non-Financial Firms w/ Sales > 300 M
Years 1991-2004
EDF < 20%
1 2 3 4 5 6 7 8
49 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Does the Predicted Default Rate (EDF) match the Actual Default Rate?
EDF = 20%
Predicted and Actual Number of DefaultsUS Public Non-Financial Firms w/ Sales > 300 M
Years 1991-2004
1 2 3 4 5 6 7 8
50 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Do EDF Measures provide Discriminatory Power over that provided by Agency Ratings?
Study Performed by 3rd Party on behalf of prospective client, published in Risk Magazine
103 Non-Financial Single B firms on 12/31/92 were sorted by their EDF, as shown on the next slide.
Observed wide range of risk (as measured by EDFs) from 0.15% to 20%.
1 2 3 4 5 6 7 8
51 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
103 B-Rated Firms as of 31/12/92
Number
of Firms
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
EDF RangeEDF Range High RiskLow Risk
52 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Defaults 6 Months Later
Number
of Firms
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
EDF RangeEDF Range High RiskLow Risk
53 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Defaults 1 Year Later
Number
of Firms
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
EDF RangeEDF Range High RiskLow Risk
54 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Defaults 2 Years Later
Number
of Firms
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
EDF RangeEDF Range High RiskLow Risk
55 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Defaults 3 Years Later
Number
of Firms
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
EDF RangeEDF Range High RiskLow Risk
56 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Defaults 4 Years Later
Number
of Firms
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
EDF RangeEDF Range High RiskLow Risk
• Equal rated firms do not have the same risk• EDF adds significant discriminatory power
57 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Benefits of the EDF™ Credit Measure
Evaluate Default Risk with a greater degree of accuracy and objectivity.
Quantify Default Risk, to:
1. Price appropriately
2. Improve portfolio performance.
Focus resources where they add the most value.
EDF is updated frequently and provides early warning of changes in credit quality.
Cause-and-Effect model facilitates What If and Pro-Forma Analysis.
1 2 3 4 5 6 7 8
58 Measuring & Managing Credit Risk - EDF™ Credit Measures Copyright © 2006 Moody’s KMV Company. All Rights Reserved.
Summary
1. What is the EDF credit measure?
Forward-looking Probability of Default over a defined time horizon
2. When does a firm Default?
Market Value of Assets < Default Point
3. What drives the EDF credit measure?
Market Value of Assets, Default Point, and Asset Volatility
4. How are the EDF Drivers calculated?
5. How is the EDF measure calculated from the EDF Drivers?
Distance to Default is empirically mapped to EDF via the Default Database
6. EDF methodology summary
7. EDF validation
The EDF measure is accurate and powerful; it provides significant early warning.
8. Conclusion
1 2 3 4 5 6 7 8
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