Question

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

Answer 1

KMV Model is used for the estimation of the default probability of a company. Here, default means that the situation or the event when the company's market net worth is below zero or is negative.

Disadvantages of this model are:

1. Subjective estimation of the input parameters are required.

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

3. Private firms’ EDFs can be calculated only by using some comparability analysis based on accounting data.

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

5. The quantity called distance does not exist because of which calculation cannot be simplified.

6. The liability level is substitued with a structure which is not very realistic.

7. The normal distribution being used to compute the probability of default rather than any other imperical distribution.

Note: EDF - It is a probability that a given firm will default within 1 year according to the method used in KMV model.

Influence on the analysis of loan decision:

1. The credit risk will not be determined truely because of the liability level structure being used for the comparison with the defaults.

2. The distinguishing feature between the bonds, collateral, covenants or convertibility will make it difficult to decide whether giving loan is a right decision or not.

3. If the asset return normality cannot be estimated it will make it difficult to decide the loan parameters.