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Measuring & Managing Credit Risk:Understanding the EDF™ Credit Measure for Public Firms
2004
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
2
1: THE CRITICAL ISSUE IN CREDIT
2: CALCULATING THE EDF CREDIT MEASURE
3: TESTING THE EDF CREDIT MEASURE
AGENDA
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
3
1 THE CRITICAL ISSUE IN CREDITSECTION
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
4
The Critical Issue in Credit
• The critical element in successfully managing a credit risk portfolio is that you must manage the dynamics of credit risk
• Why? A handful of names whose risk has changed explains most of the risk in credit portfolios
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
5
A Handful of Names Drive Most of the Risk
Managing outliers is important because a relatively small segment that disproportionately drive risk – most of the portfolio requires very little attention
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
6
Objectives in Modeling Default Risk
• Measure credit risk in terms of default probabilities rather than ordinal rankings
• Provide the most accurate forward-looking, causal model
• Provide frequent updates and early warning of changes in credit quality
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
7
Validation
Moody’s KMV EDF credit measures
• Have been tested on over 29 years of data representing over 4,000 defaults in the United States alone, as well as on smaller samples in various countries around the globe
• Outperform internal and agency ratings, simple Merton models and statistical scoring models in anticipating credit events and default
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
8
EDFs Predict Future Default Rates
0.09% 0.07% 0.42% 0.44%
1.25% 1.05%
3.82% 3.57%
15.21%
16.63%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
.02%-.20% .21%-.70% .71%-2.0% 2.01%-7.0% 7.01%-20%
Predicted and Actual Default RatesCohorts Reformed
EDF (Predicted)
Observed Default History
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
9
The EDF Credit Measure
• EDF means Expected Default Frequency—the probability that a firm will default within a given time horizon
• We provide EDF term structures out to 5 years
• EDF Ranges from 2 to 2000 basis points
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
10
The EDF Credit Measure
• A company with a current EDF credit measure of 2% has a 2% probability of defaulting within the next twelve months. If we create a portfolio of 1000 such companies, on average, 20 default over the next year, and 980 do not.
• A company with a 2% EDF credit measure is 10 times more likely to default than a firm with a 0.20% EDF credit measure.
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
11
2 CALCULATING THE EDF CREDIT MEASURE
Expected Default Frequency for firms with publicly traded equity
SECTION
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
12
Drivers to the EDF Credit Measure
• Leverage– Market Value of Assets
vs.– Book Value of Liabilities
• Risk– Volatility of Asset Value
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
13
Leverage
Market Value
of Assets
Default Point
(Liabilities Due)
DefaultedNovember 2001
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
14
The Market Value of Assets
• The market value of the business, reflecting the equity market’s expectations of future cash flows
• Not directly observable—implied from the market value of equity and the book liabilities using option pricing theory
• Reflects deterioration & improvement before book assets or earnings
• Market values are dynamic and forward looking; they are the source of the model’s predictive power
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
15
Calculating Market Value of Assets
• Equity derives its value from the cash flows of the firm.• Equity is a call option on the firm’s assets: the right,
but not the obligation, to “buy” the firm’s assets from the lender by re-paying the debt.
Standard Options Terms
Call Option Value
Strike Price
Implied Underlying Asset Value
KMV Approach (Vasicek/Kealhofer Model)
= Market Value of Equity
= Book Liabilities
Implies Market Value of Assets
For more quantitative detail, please see the Moody’s KMV paper Modeling Default Risk.
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
16
Using Options Framework to Solve for Market Value of Assets
Option Value
Underlying Asset Value
0
When we know the Asset Value, and the Strike Price
We can calculate the implied option value
Strike Price
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
17
Using Options Framework to Solve for Market Value of Assets
Equity Value (Option Value)
0
And Calculate theImplied Asset Value
For public firms, we can observe the “option value” and the strike price
Underlying Asset Value
Liabilities Due
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
18
The Default Point
• A measure of the liabilities due in the event the firm is in distress
• Non-cash and long-term obligations put less financial stress on the firm
• Firms often increase leverage as they deteriorate
• The Default Point captures the point where the typical firm defaults
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
19
Default Point: An Example
Defaulted
Market Value of Assets
Default Point
Total Liabilities
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
20
Asset Volatility: A Measure of Business Risk
• The uncertainty around the market value of the business
• Reflects the degree of difficulty in forecasting the future cash flows
• Quantifies business risk: larger firms in the same industry tend to have lower volatility
• Computed by “de-levering” Equity Volatility
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
21
Asset Volatility: A Critical Driver
Time
Rising Equity Market Cap
Because of rising Asset Volatility
But a Dramatically Higher EDF
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
22
Putting It All Together
1 Yr
Distribution of asset value at horizon
AssetValue
Today
EDF
Time
Value
Default PointDistance-to-Default =3 Standard deviations
Asset Volatility(1 Std Dev)
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
23
How do we move from Distance to Default to a probability?
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
24
• We cannot use a statistics textbook.
• The probability from the Normal distribution is too low.
• Credit risk isn’t normal!• Statistics books don’t go
beyond 3.49—we see firms that are 4-6 standard deviations from default subsequently defaulting.
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
25
From Distance-to-Default to EDF
• Moody’s KMV uses actual default rates for companies in similar risk ranges to determine a functional relationship
• Requires a large database of actual defaults
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
26
Moody’s KMV Public Company Default Database 1973–2001
0
10
20
30
40
50
60
70
80
90
Nu
mb
er
of
De
fau
lts
• Over 29 years of data• Over 4,900 defaults• Over 400,000 company-years
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
27
Scaling DD to EDF
Form a “bucket of similar DD companies 1/1/1978
4.8 4.8
4.9 4.95 5.0
5.1 5.1 5.2
4.8 4.8 4.8
4.9 4.95 5.0
5.1 5.1 5.2
4.8 4.8 4.8
4.9 4.95 5.0
5.1 5.1 5.2
4.8
1 year later, how many have defaulted? 2 years later...
• Repeat the exercise for all ranges of DD
• Measure forward default observations for periods from 1 year to 5 years
• Form new buckets every year through the present and repeat steps
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
28
Scaling DD to EDF Credit Measures
Distanceto Default
ExpectedDefaultFrequency
EDF 43 bp
DD 4s
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
29
Summary: Measuring EDF
• Estimate asset value and asset volatility– Equity is a call option on asset value– Solve for implied asset value and volatility
• Calculate Distance to Default– Contractual obligations determine Default Point– Number of standard deviations from default
• Scale Distance to Default to EDF– Assign EDF using actual historical default rates
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
30
EDF Credit Measures
• We have been working on developing EDF credit measures and helping lenders and investors on real credit portfolios since 1989.
• We are on about the 5th generation of the Vasicek-Kealhofer EDF model.
• Experience pays off—we provide the most accurate and timely assessment of credit and default risk.
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
31
3 TESTING THE EDF CREDIT MEASURESECTION
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
32
EDF Credit Measure ResultsCan Market Information Improve Ratings?
• Moody’s KMV uses equity market information to determine a firm’s probability of default: the EDF credit measure.
• Here we sort the Non-Financial Single B firms on 12/31/92 by their EDF, as shown on the next slide.
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
33
103 B-Rated Firms as of 12/31/92
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
34
Defaults 6 Months Later
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
35
Defaults 1 Year Later
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
36
Defaults 2 Years Later
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
37
Defaults 3 Years Later
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
38
Defaults 4 Years Later
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
39
Defaults 4 Years Later
EDF Range
Number
of Firms
EDF Range High RiskLow Risk
0
2
4
6
8
10
12
14
0.15-0.65
0.67-1.14
1.15-2.04
2.16-2.63
2.69-3.33
3.69-5.32
5.64-8.49
8.84-20.00
• 103 Non-Financials Rated Single B as of December 1992• 14 Defaults in 4 Years• 13 defaults from the above-median EDF companies
• Non-Defaulting firms had 2.26% EDF• Defaulting firms had 13.89% EDF
Equally rated firms are not the same risk
Market data can add precision to traditional analysis and accounting-based evaluations
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
40
EDF Predictive Power
Random Chance
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
41
EDF Prior to DefaultTotal Universe
0
1
2
3
4
5
6
7
8
9
10
-5 yr
s
-4 yr
s
-3 yr
s
-2 yr
s-1
yr 0
EDF Provides Early Warning
1 to 60 Months Prior to Default
Median EDF of firms that subsequently default
Weakest Quartile EDF all firms
Benchmark: Median EDF for period for all firms
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
42
EDF Provides Early Warning
1 to 60 Months Prior to Default
EDF Prior to DefaultTotal Universe
0
1
2
3
4
5
6
7
8
9
10
-5 yr
s
-4 yr
s
-3 yr
s
-2 yr
s-1
yr 0
Weakest Quartile EDF, firms that subsequently default
Best Quartile EDF, firms that subsequently default
Median EDF of firms that subsequently default
Weakest Quartile EDF all firms
Benchmark: Median EDF for period for all firms
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
43
EDF Provides Early Warning
1 to 60 Months Prior to Default
EDF Prior to DefaultTotal Universe
0
1
2
3
4
5
6
7
8
9
10
-5 y
rs
-4 y
rs
-3 y
rs
-2 y
rs
-1 y
r 0
Weakest Quartile EDF, firms that subsequently default
Best Quartile EDF, firms that subsequently default
Median EDF of firms that subsequently default
Weakest Quartile EDF all firms
Benchmark: Median EDF for period for all firms
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
44
EDF Predictive PowerValidated Defaults in Firms with $300mm or more in sales
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
45
50%
55%
60%
65%
70%
75%
80%
85%
90%
-1-3-6-9-12Months before upgrade/downgrade
Non-investment gradeUpgrades
Investment gradeDowngrades
Non-investmentDowngrades
Investment grade Upgrades
Upgrade/Downgrade Study
The test was fairly conservative – to signal a ratings change, a firm had to have an EDF™ credit measure that indicated a full notch or more difference at the point X months ahead of the rating change. This means the EDF had to be 2 or more times the EDF of its grade.
Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms
COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW.MOODYSKMV.COM
46
To Learn More
Please contact your Moody’s KMV client representative or visit us online at www.moodyskmv.com.
Contact Moody’s KMV via e-mail at info@mkmv.com
or call us at:
NORTH AND SOUTH AMERICA, CALL:
+1 (866) 321-MKMV (6568) or +1 (415) 296-9669
EUROPE, THE MIDDLE EAST, AFRICA, CALL:
+44 (20) 7778-7400
ASIA PACIFIC, CALL:
+81 (3) 3218-1160
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