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Explain how the KMV model predicts bankruptcy probability?

Explain how the KMV model predicts bankruptcy probability?

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Expert Solution

To explain how KMV Model helps in predicting the bankruptcy probability, we'll get to know the terms mentioned in the question and then get into the explanation.

Bankruptcy is a situation where a company cannot pay obligations to it's creditors, suppliers. This is also called as Insolvency. There are many models that predict the bankruptcy probability like Altman Z's score and Merton Model.

We'll now look into KMV Model. The steps are mainly involved in Asset Valuation, determining asset's volatility , calculating the Distance to default, and calculate expected default frequencies. Here Distance to default helps one to know how near the firm is to default or how safe it is with respect to the asset's volatility.It also considers the quality of credit cycle and credit absorbed in the operations by conducting monitoring process. It uses the historical database and helps improve the predictability. Level of default risk compares net worth's volatility with respect to the shareholder's value.

jeff jeffy answered 1 month ago
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