Forecast default risk of the corporate bonds

using KMV model

The objective of the project is to estimate the corporate bond default
using the KMV model and assign the rating based on its probability to
default. Moodys KMV model has shown that the distance-to-default does
a good job in predicting corporate defaults.
Calculate the distance to default (DD)
A key concept underlying the KMV approach is the recognition that a firm
does not have to default the moment its asset value falls below the face
value of debt in fact default happens when value of the firms assets
falls somewhere between the value of the short term debt and the value
of the total debt. In other words, it is possible to not have default even if
the value of the assets has fallen to less than the total debt. This is
natural because it is generally the current cash needs (driven by short
term debt) that cause default the firm may have enough cash to keep
paying all liabilities as they come due even though the total liabilities may
be greater than the total assets.
KMV sets the default point as somewhere between short term debt (STD)
and the total debt as the total of the short term debt and half the value of
the long term debt.

Next, the KMV approach determines what the distance-to-default is. The
distance to default is the number of standard deviations assets have to
lose before getting to the default point (DPT). It is calculated as follows:

Where is the standard deviation of future asset returns. Each of the

terms in the equation above are explained below:

This can be expressed another way as a multiple of the standard

deviation of the expected returns.

where and are the mean and volatility of the asset returns.

Sampling Frame
The sampling frame is the corporate bonds traded in the exchange in
India. The data is available in the NSE India website
(http://www.nseindia.com/products/content/debt/corp_bonds/cbm_reportin
g_homepage.htm)
Snapshot the data

Limitations of the project

The volatility of corporate bonds depends on the company performance
and market volatility. In case there is bull spread and company is
performing badly, the bonds of the company will still be traded well in the
market. This is a limitation of the KMV model as the above scenario affects
the volatility of the assets and hence in calculating the Distance to
Default.
References
1. https://www.riskprep.com/all-tutorials/37-exam-31/127-the-kmvapproach-to-measuring-credit-risk
2. IMF Working Paper - Market-Based Estimation of Default Probabilities
and Its Application to Financial Market Surveillance by Jorge A. ChanLau