Question

What are the main disadvantages of the standard KMV model? Explain how these disadvantages influence the analysis of loan decisions

Answer 1

This model has been extended by the KMV Corporation for the measures of default risk. It is a default forecasting model that produces a probability of default for each firm at any given point in time. KMV model which in fact is a modified version of the Merton’s concept. KMV implements defaulting as the Default Point which is roughly estimated by the sum of all the Short Term Debt and half of the Long Term Debt. The KMV model allows any number of debt and non debt fixed liabilities. The KMV approach implements an intermediate phase of computation of an index called Distance to Default

The KMV model primarily focuses on the probability of default of the company. The KMV framework comprises following assumptions -

1. own default probability
2. own asset return distribution
3. own capital structure

The KMV framework is based on Expected Default Frequency (EDF) for each position in the credit portfolio.EDF is a forward-looking measure of actual probability of default and KMV model is based on the structural approach to calculate EDF

Disadvantages of standard KMV Model-

1. The KMV model does not assume that asset values are normally distributed.

2. The KMV model does not use the cumulative normal distribution to convert distance to default into default probabilities.

3. The model requires some subjective estimation of the input parameters.

4. The KMV model doesn’t include all relevant information for default prediction

5. It is difficult to construct theoretical EDF’s without the assumption of normality of asset returns.

6. It does not distinguish among different types of long-term bonds according to their seniority, collateral, covenants, or convertibility

how these disadvantages influence the analysis of loan decisions-

As the KMV model does not assume that asset values are normally distributed but rather the KMV model uses its large historical database that contains data on historical defaults and bankruptcy frequencies, to obtain a relationship between distance to default and default probabilities.

KMV model is the method that the credit risk of loans is determined by the debtor's asset market value if liability is given. But assets don’t really exist in the market transactions, the market value of the company’s assets can’t be directly observed. Hence the model will transfer the view of the bank's loans, considering the issue of the borrower themselves repaying the loan.