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Topic Title: KMV and Merton model
Created On Mon Oct 03, 05 03:08 PM
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Antonios
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Mon Oct 03, 05 03:08 PM
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My question is towards the KMV-Merton methodology of calculating the probability of default. What is not clear to me is whether this is a VaR methodology or, in case it is not, how one can convert it into such.
 
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Antonio
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Mon Oct 03, 05 03:16 PM
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Could you be more precise by "VaR methodology" ? The KMV-Merton model relies on calculating the Distance to Default with assumptions on the dyna;ics of the assets and a certain structure of the debt.


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Antonios
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Mon Oct 03, 05 03:31 PM
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To be more precise, can we construct a Loss/Gain distribution via KMV-Merton and then derive a quantile representing the max. loss over a selected time horizon?
 
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Anthis
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Mon Oct 03, 05 05:16 PM
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You two are not the same person, right?
 
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Antonios
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Mon Oct 03, 05 05:24 PM
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No we are not the same person. What about ny question? Do you have any hints?
 
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virus
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Get the Expected Default Frequency (EDF) for each asset, and the default correlations, plot the joint distribution of the expected losses. This would be your loss distribution. Get your percentile off this.

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Antonios
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For the case I deal with a single asset, do you think I can produce a distribution of losses/gain through Monte Carlo simulation?
 
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gee
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Sat Oct 08, 05 04:07 PM
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The KMV-Merton default forecasting model produces a probability of default for each firm in the sample at any given point in time.

Once you have this probability matrix, you can choose a particular point (say, the 95th quantile, for example) and multiply it by you firm?s value ? since at max you can loose the firm. This will be close in function to that of VaR.

 
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erstwhile
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Sat Oct 08, 05 10:26 PM
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In principle, the advantage of a MC sim like this is that you should be able to simulate the value of all the firms assets and liabilities, and derivatives on all these, self consistently using one simulation!

But sadly this type of structural model is far too simplified and naive.

I think it is best used for educational purposes, or at best for screening large numbers of companies so that unusual debt-equity situation jump out at you. You can then perform fundamental analyses to determine what is going on.

I am by no means the first to make such criticisms - it is pretty widely accepted that a better type of model is needed. Equity vs credit trading highlights such weaknesses.

What exactly are you trying to calculate VaR for? And how would the VaR number be used?
 
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secondMan
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Mon Oct 10, 05 08:59 AM
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i must damit i do not get the discussion. someone is asking on edf, someone is mixing it with default corr and then erstwhile seems to top it by shifting the level north by a mile.

i am not sure where the initial poster, toni, right?, stands. my understanding is that EDF is already an outcome of a distribution, where the position on the horizontal axis is defined by the default point. IMHo you could see this point as a VAR and the edf is the appropriate likelihood (better to see 1 minus this likelihood). as far as i know in some of their presentations KMV include other such probs in order to illustrate how different positions of the default point result in different ratings. actually i just ask myself what distribution they assume in the first place. since they claim their optionRoots, maybe lognormal?

maybe i am just adding noise here ...



erstwhile
in my opinion the real issue is less the model, but the source of one ingredient: the multiplier of debt in order to derive the default point. it is clearly below 1 (at least it appears to be to me), but the figure is quite debateable IMHO. if KMV derives it out of their database, thus calibrating it to different industries using default data, this might offset the limitations you mention. but i would think that your a mile northwest ...

peace

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Edited: Mon Oct 10, 05 at 11:07 AM by secondMan
 
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erstwhile
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secondman - there are loads of problems with the very simplified KMV type of structural model. one particularly glaring one is the notion that "enterprise value" is well represented by the sum of market capitalisation and debt.

think about Cisco systems in the year 2000 - the market cap was huge - would that make you want to lend them money? were they a better credit then, when their stock price was multiples of what it is now?

then there is the problem of the time distribution of debt - KMV merely adds it all up. some companies have no significant debt due for 20 years, and other have most of their debt due in 3 years. with all else held constant, KMV would not distinguish between these two situations.

never mind all the other issues, like details of when a company can be refinanced, the fact that this may vary between sectors and countries, etc. or there is sometimes the probability of a government bailout, which can be a huge factor, but which would be ignored in a simplified model.

i do think it is good for educational purposes and as a screening tool though.

as far as the original question went, I think that was to do with the KMV model and VaR. i assumed the idea was to convert KMV/Creditgrades into a MC sim for VaR. doable, but not good, IMO.
 
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secondMan
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i thought that KMV reflects the debt structure in their default point calibration. well, not purely idosyncratic since they do that sectorwise i think. IMHO CSCO at 80 [given same absolute level of debt, which will not be the case i guess ] is definitely less likely to default than below 10. but we come from different corners of the world. for me the pure fact that they use market data to determine default debt is already a huge advantage. debt equity modelling is still new to me ...

BTW what data sources on balance sheet data would you recommend, life and historic? compustat? are there others? i am contemplating to revive a multiregression equity market neutral factor model (APT kind of thing) on balance sheet data. (and i am a little annoyed with bloomberg, who corrects data after the fact, without leaving dates of the correction.)

peace


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erstwhile
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Tue Oct 11, 05 10:13 AM
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CSCO went from $80 to $15 in a year. i doubt that the company's "true creditworthiness" (vague, but intended to be a common-sense concept) was dramatically different in that period. we can agree to disagree on this point.

personally i haven't looked at historical balance sheet data - i couldn't tell you where to get it from.

i have only used creditgrades types models using Bloomberg balance sheet data - i agree it is pretty chaotic sometimes.

i am giving several talks at conferences on equity-credit trading in the next few months, and my final conclusion will be that fundamentally based analysis on the equity and debt of individual companies needs to be done to form a sound investment strategy. things like KMV/Creditgrades/Merton models, or multifactor regressions should not be the core analysis performed in commiting capital.
 
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Jaxx
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Tue Oct 11, 05 04:46 PM
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I don't think I agree on the CSCO point. With the stock at $80 the balance sheet is in better shape and they have much better refinancing options - its only with a degree of hindsight that you can dismiss the information content of the ridiculous share price, particularly as to the potential future cash flows this was discounting.
 
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secondMan
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Wed Oct 12, 05 08:44 AM
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Quote

Originally posted by: erstwhile
CSCO went from $80 to $15 in a year. i doubt that the company's "true creditworthiness" (vague, but intended to be a common-sense concept) was dramatically different in that period. we can agree to disagree on this point.

personally i haven't looked at historical balance sheet data - i couldn't tell you where to get it from.

i have only used creditgrades types models using Bloomberg balance sheet data - i agree it is pretty chaotic sometimes.

i am giving several talks at conferences on equity-credit trading in the next few months, and my final conclusion will be that fundamentally based analysis on the equity and debt of individual companies needs to be done to form a sound investment strategy. things like KMV/Creditgrades/Merton models, or multifactor regressions should not be the core analysis performed in commiting capital.



hmm. i see your point and i sense where you are heading. yes, a bubble is a bubble. and i assume that each and every model will have its flaws under extreme circumstances. it might be completely insane to analyse high growth companies by their current balance sheet, since their value might be always much more driven by forecasts. (not necessarily "fantasy"). and let us not forget: after the fact we all are wise.

i think in principle you will agree that a stock trading at 80 will have different default prob than one at 10. interesting thing BTW, does anyone know studies an on that? (alwys thinking in terms of market cap and not directly price of course.)

can you "publish" material on your talk after you delievered them? would love to here something on that. do you kow a market neutral bond (or cds) fund? pairs trading bonds? that kind of thing ...



[BTW am i the only one who thinks CDS is unethical, given that it is 70% of traded bond volume, yet does not provide a single $ for the companies ...?]

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erstwhile
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Wed Oct 12, 05 11:21 AM
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secondman - yes, you are seeing my point. a fundamental analyst might have looked at CSCO when it had a $500bn market cap and realised that it was pricing in some insane level of earnings growth, and decided that the implied earnings were not dependable. if csco had wanted to raise $100 billion i think in reality it might have had a hard time convincing a loan officer. the point is actually moot as they were awash with cash!

i do agree that all else held equal (like total amount of debt and its maturity profile), if one company in a sector had a great looking earnings potential, and another had a dire earnings potential, and if the stock prices reflected this, then the company with the better earnings stream should have a lower probability of default. but i would want an (internal) equity analyst and a debt analyst to be convinced before i committed capital to any related trade. i would never trade off of KMV/Creditgrades models alone.

regarding "market neutral" credit funds, i expect there are quite a few.

i'll see what i can do about publishing my slides - though they are mainly slides with bullet points to remind me of what the next topic is!

i don't think CDS contracts are unethical - especially if the total CDS open interest is less than or equal to the outstanding debt of the company. in that case, all that is happening is that the company's default risk is shifted to the person most willing to take it on.

if the the CDS market is bigger than the debt of the company, speculators may get blown up when it comes to deliver unavailable bonds!!

deliverability: reminds me of something from the early 90s - the london stock exchange decided to bring in a rule stating that if the underlying stock in an OTC option contract was more than 3% of the stock of a company, the buyer of a call would have to make a public announcement. so another dealer and i were going to trade an OTC call option on 100% of the capitalisation of the entire FTSE100 index, but put the strike so far out of the money that the option was worthless. but neither of us wanted to be the buyer and end up in the newspapers...
 
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secondMan
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Wed Oct 12, 05 03:43 PM
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in the late nineties (the time when exotic options become quite popular on equity baskets) a colleague wanted to sell an exotic option to another bank which looked fairly simple in the first place but would lead to unlimited payout in some instances. we thought of selling it (at discount) to banks and expected to collect one out of one hundred once in a while. i still like the idea ... though risk management at institutions might be more aware of such things now ...

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erstwhile
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Wed Oct 12, 05 08:20 PM
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funny one! shouldn't get too far off topic, but inthe early 90s we had a pricing request for a call on 1/spot, where spot is a stock price. the quant was overjoyed to find an analytic solution but we declined to quote ...

given a nonzero credit spread guess what the price of that derivative is?

Edited: Wed Oct 12, 05 at 08:21 PM by erstwhile
 
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Jaxx
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Thu Oct 13, 05 11:15 AM
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how i wish i was 20 years older...
 
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