Under the KMV Moody’s approach to calculating expecting default frequencies (EDF), firms’ default on obligations is likely when:

Under the KMV Moody’s approach to calculating expecting default frequencies (EDF), firms’ default on obligations is likely when:
A . expected asset values one year hence are below total liabilities
B . asset values reach a level below short term debt
C . asset values reach a level below total liabilities
D . asset values reach a level between short term debt and total liabilities

View Answer

Answer: D

Explanation:

An observed fact that the KMV approach relies upon is that firms do not default when their liabilities exceed assets, but when asset values are somewhere between short term liabilities and the total liabilities. In fact, the ‘default point’ in the KMV methodology is defined as the short term debt plus half of the long term debt. The difference between expected value of the assets in one year and this ‘default point’, when expressed in terms of standard deviation of the asset values, is called the ‘distance-to-default’. Therefore Choice ‘d’ is the correct answer. The other choices are incorrect.