Credit Risk – KMV - Approach

FRIEDRICH-ALEXANDER UNIVERSITY ERLANGEN-NUREMBERG
CHAIR OF STATISTICS AND ECONOMETRICS
Term paper
Winter semester 2007/08
„Credit Risk – KMV - Approach“
Schott, Robert
Semester: 8
Business Economics

Contents
Contents ... I
List of Tables ... II
List of Figures ... III
List of Abbreviation ... IV
1 The Need for Credit-Risk Measurement ... 1
1.1 Basel Accords ... 1
1.2 Risk in the Three Pillars ... 2
2 Credit Risk ... 2
2.1 Major Risk Components ... 2
2.2 Credit Risk Models ... 4
3 KMV ... 4
3.1 Merton Approach ... 5
3.2 Characteristics KMV Model ... 6
3.3 KMV Approach ... 6
3.3.1 Value of Assets ... 7
3.3.2 Default Point ... 8
3.3.3 Distance to Default ... 8
3.3.4 Expected Default Frequency (EDF) ... 9
3.3.5 Loss Distribution ... 11
3.3.6 Default Predictive Power ... 11
4 Risk Measurement in Practice ... 11
Attachment ... 13
References ... 17

1 The Need for Credit-Risk Measurement

“Until the 1990s, corporate credit analysis was viewed as an art rather than a science because analysts lacked a way to adequately quantify absolute levels of default risk. In the past decade, however, a revolution in credit-risk measurement has taken place. […]“
[Stephen Kealhofer, 2003] ¹

1.1 Basel Accords

On January 1st 2007 the European directives (2006/48/EG)² and (2006/49/EG)³ concerning minimum capital requirements, which are equivalent to the new Capital Accords elaborated from the Basel Committee on Banking Supervision (BCBS), were put into German national legislation.⁴ The basic aim of the Basel Accords is to gear banks’ capital requirements more closely than in the past to the actual economic risk, which should improve security and soundness of the financial system.⁵ Thus an accord becomes operative, which had its beginning in the year 1988 with the publication of the Basel Accord (Basel I). The BCBS is retaining key elements of the capital adequacy framework (1988), but the revised framework gives greater consideration of assessments of risk provided by banks’ internal systems as input to capital calculations.⁶

1.2 Risk in the Three Pillars

The International Convergence of Capital Measurement and Capital Standards, in the term paper now named as the well-known Basel II, provides three pillars each dealing with risk, which can be seen in figure 1. ⁷

- figure will be present in complete article -

As you can see in figure 1 different approaches are provided to deal with credit risk, either the Standardized Approach or the Internal Ratings Based Approach (IRB), which includes again two broad approaches, namely the foundation and the advanced approach. One reason for banks to prefer IRB in opposition to the Standardized Approach is that a ....

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1 Cp. Kealhofer, S., Quantifying Credit Risk I: Default Prediction, p. 30.
2 Directive 2006/48/EC.
3 Directive 2006/49/EC.
4 Cp. Deutsche Bundesbank, Solvency.
5 Cp. Deutsche Bundesbank, Basel II – the new Capital Accord.
6 Cp. Bank For International Settlement, International Convergence of Capital Measurement and Capital Standards, p. 2, para. 6.
7 Cp. Bank For International Settlement, International Convergence of Capital Measurement and Capital Standards, p. 6.