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A MERTON-MODEL APPROACH TO ASSESSING THE DEFAULT RISK OF MALAYSIA PUBLIC COMPANIES
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3761 Corporate Master in Business Administration T314 2013 2013
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Pusat Khidmat Makll!mat Ak:idemik(J
U~IVERSITI MALAYSIA SARAWAK
P.KHIDMAT MAKLUMAT AKADEMIK
11111 IIIIIfiiffllllill III
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1000246877
A Merton-Model Approach to Assessing the Default Risk of Malaysia Public Companies
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\ By
Teo TaiWang (11031898)
A Research Paper Submitted in Partial Fulfillment of
the Requirement for the Degree of
Corporate Master in Business Administration
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Faculty of Economics and Business UNIVERSITY MALAYSIA SARA W AK
(2013) 'j
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, APPROVAL PAGE
I celtified that I have supervised and read this study and in my opinion it conforms to
acceptable standards scholarly presentation and its fmlly adequate in scope and quality as
research paper for the degree of Corporate Master in Business Administration.
Associate Professor Dr. Mohamad Jais
Supervisor
This research paper was submitted to the Faculty of Economics and Business. UNIMAS
and is accepted as partial fulfillment of the requirement for the degree of Corporate
Master in Business Administration. \ ..
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Dr. Mohamad Affendy Arif
Dean, Faculty of Economic and Business
UNIMAS 11 I "., .1'; 'i,'I~ •
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, STATEMENT OF ORIGINALITY
The work described in this Research Paper, entitled
"A MERTON-MODEL APPROACH TO ASSESSING THE DEFAULT RISK OF
MALA YSIA PUBLIC COMPANIES"
is to the best of the author's knowledge that of the author except
where due reference is made.
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Date 1oo'TAI WANG • t
28.06.2013 (11031898) . ....
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Acknowledgement
,
Throughout my entire Corporate Master in Business Administrative (CMBA) program, I have
been blessed with encouragement and assistance from many, without whose help, I am unable to
complete the program. I would like to express my sincere thanks and appreciation to them.
I would like to express my deepest gratitude and respect for my supervisor, Prof Madya Dr.
Mohamad Jais, who has been most patient and supportive with his time and professional guidance.
With his vast experience in both the field and research, he has my understanding and interest in
research. It meant a lot to me as I had no prior research background. I am indeed honoured to be
under his mentorship.
Also, I would like to extend my special thanks and appreciation to all my lecturers in Unimas
who have unselfishly shared and imparted invaluable knowledge, understanding and a broader
outlook: Prof. Dr. Shazali Abu Mansor, Prof. Dr. Ernest Cyril De Run, Associate Prof. Dr. Puah
Chin Hong, Prof Madya Dr. Venus Liew Khim Sen, Dr. Harry Entebang, Dr. Mahani Mohamad
Abdu Shakur, Dr. Dayang Affizah Awang Merikan and Dr. Rohaya Mohd Nor.
, .. Lastly, I would like to express my -;ppreciation'lor the 'u'n-d'erstanding and supportive of my wife
Penny Chua and my children Veronica TeQ and Jonathan Teo. They are my fountain of joy. I
dedicate this study to all the lovely and respective people mentioned above. 'I ... I , i '" • [, " " " ., I , .
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Pusat Khidmat Maklumat Akadcmik UNIVERSITl MALAYSiA SARAWAK
TABLE OF CONTENTS
ACKNOWLEDGEMENT v ,
TABLE O} CONTENTS VI
CHAPTER I: INTRODUCTION
1.1 Background \ 1.2 Purpose of study 2 1.3 Problem Statement 2 1.4 Research Objective 3 1.5 Research Question 3 1.6 Definition of Key Terms 4 1.7 Significance of Study 7 1.8 Scope of Study 7 1.9 Organization of Chapter 8
CHAPTER 2: LITERATURE REVIEW
2.1 Introduction 10 2.2 Merton Model 12 2.3 Modeling Default Risk 17
2.3.1 Estimate asset value and volatility 21 2.3.2 Calculate the Distance-to-default 24 2.3.3 Calculate the Default Probability 24
2.4 Other studies 27 2.4.1 Of Moody's and Merton 27 2.4.2 Default Forecasting in KMV 27 2.4.3 A Merton-model approach to assessing the default risk of UK public companies 28
2.4.4 Forecasting Bankruptey More A~.~w:~tYlY..... ".~.. 29 2.5 The Malaysia scenario . '. .~, ~ i{'~ ' 30
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CHAPTER 3: METHODOLOGY
313.1 Intq:>duction 343.2 Re~arch Design 363.3 Implementation of Research Design 373.4 Sample and data description
3.3.1 Criteria of PN 17 Companies 38
393.3.2 Obligations ofPNI7 Company 403.3 .2.1 Regularization plan
3.3.2.2 Disclosure obligations ofPNI7 Company 40
' 423.3.2.3 Obligation to Regularize 453.3.3 List ofPN17 Companies
CHAPTER 4: FINDINGS
534.1 Introduction 544.2 Analysis of Results 564.3 Conclusion
CHAPTER 5: DISCUSSION
575.1 Introduction 575.2 The Backdrop 585.3 Discussion of Hypothesis Testing 595.4 Implications
5.5 Strengths and Limitations 595.5.1 Strengths 605.5 .2 Limitation 615.6 Directions for future Research 625.7 Conclusion
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63REFERENCE . '65APPENDIX I ... .'".. Sample of distance-to-default calculation ... _
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CHAPTER 1
INTRODUCTION , ,
1.1 Background
~n finance, investment is putting money into som thing with the expectation to gain
either by appreciation in value or a constant cash flow stream generated from that
asset, usually over a longer period. Investments come in verities of form, ranking
from holding tangible asset like properties to intangible asset like financial instrument
such as security or debts. All form of investments involves some fonn of risk such as
investment in equities, property, and even fixed interest securities which are subject to
inflation riV
Equity stock or share in a public listed company is one form of the investment
instrument with long term prospect. This is because equity share offer two type of
return to the investor. One is the capital gain from price appreciation of the share due
to company's profit from its operation, secondly, profitable company will distribute
dividends to its shareholders on a annual or bio-annual basic base on the performance
of the company. Sometime company even distribute bonus share to its shareholder.
Also invested in public listed company's share could provide liquidity to its holder as
it can easily dispose off. Therefore. shar~ investment is a attracting investment :" . ~.:," :" - .~, ~.' .~: ' "- 1
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instrument. Bursa Malaysia the stock exchange in Malaysia as at 31 March 20 I I, has a
market capitalisation of MYR1.287 triHion (I) (equivaient to USD429 billion) with
959 companies list on the Main board (2).
(I) source: from Wikipedia. the free encyclopedia '. (2) source: Bursa Malaysia website (hllp:l!www.(JllrliCunalaYliiOl'oom!I/(;sc!/)"sling 'contact Iist.pdf) . ,' , . , -
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1.2 Purpose of study
The purp3se of this study is to examine the effecti veness of using Merton-model style , of approach to measure the probability of failure of individual public company listed
in Bursa Malaysia in order to mitigate the default risk exposure by investors when
they invested in the Malaysia stock market. Althou h business failure could due to
various risk like market risk, liquidity risk, operational risk etc. For this study, the
main focus is on the credit risk of the individual company. The credit risk. of the firm
is often referred as the default of the firm (Default Forecasting in KMV by Yuqian
(Steven) Lu J9 June, 2008) and in the following of this paper both term wi 11 be used
interchanged. This study will only discuss on the use of Merton-model as an
assessment tool in the measurement of the credit risk of the firm. Then the study will
assess the reliabilities of the results provided by the method.
1.3 Problem Statement
Is Merton-model able to estimate the failure of the public companies listed in Bursa
Malaysia reliably? If Merton-model is proved to be an effective measurement tools,
then current and potential investors could consider the application of the tools as a
guideline to reduce their credit risk·exp;su~e i'iid"ii'iihirmse·th~ttf..p.oteq~~.1. .tlnancial
losses. ..(',
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1.4 Research Objective
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" The objective of this research is to assess the reliability of Merton-model in
estimating the failure of the public companies listed in Bursa Malaysia by examine
their success in predicting the failure or survival of ~e failed companies. In order to
achieve this main objective, the following sub objectives have to be fulfilled:
1. To understand the mechanism of Merton-model is assessing the default
risk exposure of the firms; and
ii. Use the Merton-model to examine the failure or survival of the failure
companies which are sample pick from companies grouped under PN 17 in
Bursa Malaysia.
1.5 Research Question
I. What is Merton-model as a method available to assess the default rate of
public companies trade in the Malaysia stock exchange?
ii. What is the relationship between the default rate determined from the above
method and the actual default of the corporate bond? , .
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1.6 Deflnition of Key Terms
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Credit Rating
A credit rating evaluates the credit worthiness f a debtor, especial'ly a business
(company, corporation) or a goverrunent. It is an evaluation made by a credit rating
agency of the debtor's ability to pay back the debts and the likelihood of default. The
credit rating represents the credit rating agency's evaluation of qualitative and
quantitative information for a company or government.
Credit Rating Agency (eRA)
A Credit rating Agency is a company that assign credit ratings for issuers of certain
types of debts obligation as well as debts instruments. The largest credit rating
agencies (which operate worldwide) are Dun & Bradstreet, Moody's, Standard &
Poor and Fitch Rating.
Rating Agency Malaysia (RAM)
Rating Agency Malaysia is the Malaysia credit rating agency.
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Bursa Malaysia (KLSE)
Bursa Malaysia previously known as Kuala Lumpur Stock Exchange (KLSE,.~ ... ' .. ... ..... Bursa Saham Kuala Lumpur in Malay) is the sole stock exchange in Malaysia
which provides services for stock brokers and traders to trade stocks, bonds, and other
, . securities.
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Pusat Khidmat Maklumat Akademik UNIVERSITl MALAYSIA SARAWAJ(
Credit Risk
Credit risk refers to the risk that a borrower will default on any type of debt by
failing td'make payments which it is obligated to do. The risk is primarily that of the ~
lender and include lost on both principle and interest, disruption to cash flows, and
additional collection costs.
Bond
In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It
is a debt security, under which the issuer owes the holders a debt and, depending on
the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the
principal at a later date, termed the maturity. Interest is usually payable at fixed
intervals (semi-annual, annual and sometimes monthly). Very often the bond is
negotiable, i.e. the ownership of the instrument can be transferred in the secondary
market.
Black-Scholes
The Black-Scholes model is a mathematical model of a financial market containing
certain derivative investment instruments. From the model, one can deduce the
Black-Scholes formula, which gives a theoretical estimate of the price of European-
style options. The formul!a, developed by three economists - Fischer Black, Myron
Scholes and Robert Merton - is pertmps the wOl'ld'H1JOlOt...wsl~_~~n o.~~~~~l~ , pricing
model. (From Wikipedia and lnveslopedia)
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Default rate
Default rate is the rate of borrowers who fail to remain current on their loans. It is a
critical iJiece of information used by lenders to determine their risk exposure and ~
economists to evaluate the health of the overaU economy.
Geometric Brownian motion
A geometric Brownian motion (GBM) (also known as exponential Brownian
motion) is a continuous-time stochastic process in which the 'logarithm of the
randomly varying quantity follows a Brownian motion (also called a Wiener process)
with drift. It is an important example of stochastic processes satisfying a stochastic
differential equation (SDE); in particular, it is used in mathematical finance to model
stock prices in the Black-Scholes model. (From Wikipedia, the free encyclopedia)
Ito's lemma
In mathematics, Ito's lemma is an identity used in Ito calculus to find the differential
of a time-dependent function of a stochastic process; it serves as the stochastic
calculus counterpart of the chain rule. (From Wikipedia, thejree encyclopedia)
Wiener process
In mathematics, the Wiener process is a continuous-time stochastic process named in
honor of Norbert Wiener. It is often" called staliJaM;Brtrwt\iHo4llllO~iO\l~ ~~~~r Robert
Brown. It is one of the best known Levy processes (cad lag stochastic processes with
stationary independent increments) and ~c'curs frequently in pure and applied
mathematics, economics, quantitative finance and physics.
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1.7 Significance of Study
Equitt shares offer a higher yield and more liquidity as compared to some other ~
investments, but for a price. Today's business environment has become more
sophisticate, volatile and compl.icated coupled wi.th dynamic change in the business
environment has increased the risk face by the \ usiness. The increase in failure of
large conglomerate like Enron (2001), Worldcom (2002) and lately Lehman Brothers
which is the largest bankruptcy in US history has indicated the uncertainty faced by
investor when they invested in equity share. Therefore, it is important that investors of
equity shares are able to assess credit risk and its potential payoffs : while rising
interest rate movements can reduce the value of your investment, a default can almost
eliminate it. Holders of equity share are exposing to risk of default. Therefore it is
important for equity investors to be able to detect the risk early so as to minimise the
financial loss in case of defaults.
I.S Scope of Study
The research will be conducted at the Malaysia Stock Exchange namely Bursa
Malaysia (KLSE). The scope of the study will be the companies listed in the KLSE.
Secondary data will be collected and analys~S"~.:rhfg-r~.. Th~~ W~.ip. t s~urce of
the secondary data would be published data obtained from KLSE.
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1.9 Organization of Chapter
Chap~r one sets the research background relating to issues and facts that are pertinent ,. to this study. It also encompass the purpose of study, problem statement, research
objectives, research questions, definition of key tenns, the significance of study, the
scope of study and organization of chapters.
Chapter two will examine, compare and discuss the literature review of credit risk
assessment model and past research done on the application of this model. The
chapter will also include the theoretical framework of study and the gaps between the
literature review, justification of the theoretical framework and description of the
dependent and independent variable.
Chapter three represents the methodology in this research. It will incorporate the
research design, sample and procedure, data collection procedure, measure and
statistical analyses, such as reliability analysis, factor analysis, descriptive statistics,
correlation coefficient and liner regression, that will be used in this study.
Chapter four will discuss the results and findings from this research. It will explain
the goodness of measures, restatement of research hypotheses, inter-correlations
among study variables, hypothe;is te~ting ' and-'fri1diifgs' -of~ot~~~ . rt;sting. The
results will be seen clearly from the interpretation in the findings. Thus, the . . .... ... .... hypotheses and the relationship between the various variable can be summarized.
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Chapter five will include the discussion of hypotheses testing, the relationship
between the different variables and the conclusions drawn from the findings of this
resealch. ~
The last chapter will embody the conclusion of the overall research, recommendations
made for the various stakeholders, recommendatk,ns for future research as well as the
limitations of this study.
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CHAPTER 2
LITERATURE REVIEW
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2.1 Introduction
The Merton model is a model proposed by Robe C. Merton in 1974 by extended the
work of Black Scholes on option pricing theory for assessing the credit risk of a
company. In late 1980s, the Merton model was developed by the firm call KMV
Corporation; a firm specialized in credit risk analysis. Therefore it was also call as
KMV-Merton model. Subsequently, Moody's Corporation acquired KMV in 2002
and due to Moody's commercial characteristic as a stocks and bonds rating agencies.
The modeling choices made by Moody's KMV become a commercial secret.
Merton model links the firm ' s credit ri,k to its capital structure. The model is perhaps
the most significant contribution to the area of qualitative credir risk research by
fuqian (Steven) Lu in Default Forecasting in KMV 19 June 2008. Although it is a
widely used application and is the foundation in modeling credit risk, its relies on
some simplifying assumption about the structure of the typical finn's finances to
facili tate its implementation which in practice, these simplifying assumption are not
realistic. The Merton model makes three particularly important assumptions. The first
assumption is that the total value ~f a rim; is!iisrutn'eCn{)··f~.geo.~ettif.,Brownian. . . . • t
motion. Second, it is assumed that the firm has a simple capital structure: debts' plus
.equity and the finn only issued a single, homogeneous class of debts and thirdly is
that the event of default can only take place at the maturity of the debt when the
repayment is due. {, I I ' '" ..
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According to Merton-model, the company's equity is by characterizing as a call option
on the ubderlying value of its assets. Put-call parity is then used to price the value of a , put and this is treated as an analogous representation of the firm's credit risk. The
basic ideal of the Merton model is that it assumed that the firm will issue a bond to its
bondbolder and promise to pay them a B amount w en the bond is mature at T time. If
at time Tthe firm's assets value is above the bond repayment value B, then the firm is
able to realise its assets and settle its debt (the bond) and the shareholder get the
residual of the value. Whereas on the other hand, if the firm's assets value fall below
the debt value, the bondholders will take over the company and the equity holders of
the firm will not have anything. This means a bond issuer or an obligor is say to be
defaults when the value of the bond issuer's assets fall below or equivalent to the
value of its liabilities, or when the ratio of its liabilities to assets fall below one.
Steven Lu Yuqian in his paper Default Forecasting in KMV stated that 'This model
assume afirm 's equity could be view as a perpetual barrier option on the underlying
value of the firm's asset in a time horizon. Once the assets value of the firm drops
below some threshold level, which is also called the default point (DD), at or below
the time horizon, the firm would immediately defalllt."
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2.2 The Merton Model
The Merton model forecasting firm default by determines a probability ofdefault for
the firm at a given point in time. In order to calculate the probability of default of the
firm, the model will first estimate the market value of the firm. Then its will subtracts
the face value of the firm's debt from the estimak market value. Secondly, the model
will take this different and divided it with an estimate volatility of the firm's assets to
produce a z-score called distance to default. And lastly it will substitute the distance
to default into a cumulative density function to determine the probability that the
value of the firm will fall below the face value of its debt at the forecasting horizon.
Referring to Sreedhar T Bharath and Tyler Shllmway's research paper Forecasting
Default with the KMV-Merton Model (2004) in the KMV-Merton model there are two
particular important assumptions. Th: first one is that the total value of a firm is
asswned to follow geometric Brownian motion which can be express in the following
fonnula.
dV = /-lVdt + uvVdW (1)
Where
Vis the total value of the firm;
/-l is the expected continuously compounded return of V; ~
CTV is the volatility of firm value; and . ,
, _ J tI.....dW is a standard Weiner process; . ...
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The second assumption of the model is that the firm has issued just one discount bond
maturing in T periods. Under these assumptions, the equity of the firm is a call option
, on the underlying value of the firm with a strike price equal to the face value of the ... firm 's debt and a time-to-maturity of T. Moreover, the value of equity as a function of
the total value of the firm can be described by the Black-Scholes-Merton Formula. By
put-call parity, the value of the firm's debt is equal to the val ue of a risk-free discount
bond minus the value of a put option written on the firm, again with a strike price
equal to the face value of debt and a time-to-maturity of T.
The KMV-Merton model uses two nonlinear equations to translate the value and
volatility of a firm's equity into an implied probability of default. The first equation is
the value of a firm ' s equity as a function of the value of the firm which Merton model
stipulates as:
(2)
Where
E is the market value of the firm's equity;
F is the face value of the firm debts;
r is the instantaneous risk-free rate;
-N is the cumulative standard normal di.Stribution function;
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d, is given by
In (VIF) + ( r + O.50"~ )T ,
(3)
The second equation relates the volatility of the finn's value to the volatility of its
equity. Under Merton's assumptions the value of the equity is a function of the value
of the firm and time, so it follows directly from Ito's lemma that
v aE (JE =( E) all O'v (4)
In the Black-Scholes-Merton model, it can be shown that av = JIf{d,), so that
under the Merton model's assumption, the volatilities of the firm and its equity are
related by
V (JE =( E) JIf(d,)O'v (5)
, . where d, is defined in equation (~
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The KMV-Merton model basically uses equation (2) and (5) to translate the value and
volatil ity of the finn ' s equity into an implied probability of default. In most
appli~ation the Black-Scholes-Merton model describes the unobserved value of an ~
option as a function of four variable that are easily observed (which are strike price,
time-to-maturity, underlying asset price, and the risk free rate) and one variable that
can be estimated, the volatility. Whereas, in KM V-Merton model, the value of the
option is observed as the total value of the firm's equity, while the value of the
underlying asset (which is the value oftbe firm) is not directly observable. Thus while
V must be inferred, E is easy to observe in the marketplace by multiplying the firm ' s
shares outstanding by its current stock price. Similarly, in the KMV-Merton model,
the volatil ity of equity (JE, can be estimated but the volatility of the underlying firm
(Jr must be inferred.
Sreedhar and Tyler state the following steps in implementing the Merton model:
I. First step is to estimate the volatility of equity (JE either from the historical
stock return data or from option implied volatility data.
2. The second step is to choose a forecasting horizon and a measyre of the face
value of the firm's debt. The forecasting horizon is the time we wanted to
forecast. For example we can assume a forecasting horizon of one year (T = I).
As for measure of debt's 'face value,'!·w.~..can.~ .t~tal book value of the .. • • . .;" ~ . -: ' t ' • 1 •
finn's liabilities to be the face value of the firm's debt.
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3. The third step is to collect value of the risk-free rate and the market equity of
the fi rm. oJ
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After performing the above three steps, we would have determine the variables in
equation (2) and (5) above except for V (the total value of the firm) and crv (the
, vol~lity of firm value).
4. The forth step, perhaps is the most significant step in implementing the model
is to simultaneously solve equation (2) and (5) numerically for value Vand crv.
Once this numerical solution is obtained, the distance to default (DD) can be
calculated as:
In (V/F) + (u + O.50"~ )TDD
(6)
where Ii is an estimate of the expectei! annua'i return of the firm's assets.
The corresponding implied probability of default which sometime called the expected
defaultfreqllency (or EDF), is
In (V/F) + (u + O.5Ci,~ )T lTKMV = JI/(-{ )) = JI/( - DD)
crV\iT •
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If the Merton model holds completely, the implied probability of default defined
above, lI'KMV, should be a sufficient statistic for defau'lt forecasts.
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2.3 Modeling Default Risk
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Ifwe would refer to the report Modeling Default Risk published by KMV LLC (2002),
there are three main elements that determine the default probability of a firm:
I. Value of Assets: This is the market value of the firm's assets. We should not
confuse between the market value with book value which is the historical
value of firm's assets. Market value is the measure of future cash flows
generated by the firm's assets discounted back to the present value using an
appropriate discount rate which normally is the firm's cost of capital. With
this measure, it has incorporate the future prospects of the firm and the
relevant information about its industry and the economy.
2. Asset Risk: the uncertainty or risk of the asset value. The asset risk of a firm
is a measure of the firm's business and industry risk. This is because the value
of the firm's assets fluctuates due to the business and industry risk of a firm.
Therefore, the value of the firm's assets should always be understood in the
context of the firm's business or asset risk.
, .. 3. Leverage: is the extent of the' firrriO:S' ·eoofrattu~kf.ifttti.tie~. ~}y.Q.~reas the
relevant measure of the firm's is at their market value. the book value of
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liabilities relative to the market value of assets is the appropriate measure of
the fi rm's leverage, as this is the amount that the firm must repay.
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