Changes in which of the following do not affect the expected default frequencies (EDF) under the KMV Moody’s approach to credit risk?

Changes in which of the following do not affect the expected default frequencies (EDF) under the KMV Moody’s approach to credit risk?
A . Changes in the debt level
B . Changes in the risk free rate
C . Changes in asset volatility
D . Changes in the firm’s market capitalization

View Answer

Answer: B

Explanation:

EDFs are derived from the distance to default. The distance to default is the number of standard deviations that expected asset values are away from the default point, which itself is defined as short term debt plus half of the long term debt. Therefore debt levels affect the EDF. Similarly, asset values are estimated using equity prices. Therefore market capitalization affects EDF calculations. Asset volatilities are the standard deviation that form a place in the denominator in the distance to default calculations. Therefore asset volatility affects EDF too. The risk free rate is not directly factored in any of these calculations (except of course, one could argue that the level of interest rates may impact equity values or the discounted values of future cash flows, but that is a second order effect). Therefore Choice ‘b’ is the correct answer.