WHAT IS EDF?

Moody's Analytics developed the Expected Default Frequency (EDF) credit measure as part of
the KMV model. EDF assesses the likelihood that a company will default on payments within a
given period by failing to honour interest and principal payments, typically within a year.
The term "Expected Default Frequency" is a trademark for the default probability derived from
Moody's KMV model. Stephen Kealhofer, John McQuown, and Oldrich Vasicek contributed to
the development of the KMV model. According to EDF, a company defaults when the market
value of its assets falls below the value of its liabilities payable. The EDF model assesses credit
over a one- to five-year horizon.
KEY FEATURES OF EDF-
1. . The dynamics of EDF are primarily determined by the dynamics of equity values.
2. The default risk is determined by the distance to default ratio.
 This important ratio compares a company's net worth to its volatility.
 Because the net worth is based on equity market values, it is both a timely and superior
estimate of the firm's value.
3. The ability to adjust to the credit cycle and quickly reflect any decline in credit quality.
4. Perform best in highly liquid market conditions.
COMPONENTS OF EDF-
1. MARKET VALUE OF ASSETS
The market value of assets is not an easily observable metric, so Moody's Analytics created a
model to calculate it. The option-theoretic approach calculates the market value of assets by
using the market characteristics of a company's equity value as well as the book value of its
liabilities. The model views the company's equity as a call option on its underlying assets.
2. ASSET VOLATILITY
The dispersion of returns on a specific asset (s) owned by a company is referred to as asset
volatility. Increased volatility is viewed by investors as an increase in the risk of investing in
specific assets or companies. Volatile assets are considered high risk due to their less
predictable prices.
The standard deviation of returns from an asset or market index is used to calculate asset
volatility. If a company's assets are more volatile, there is a greater chance that their value will
fall below the default, and investors will be less optimistic about the company's market value.
3. DEFAULT POINT
The default point is the level of a company's market value of assets below which it will be
unable to make scheduled debt payments. The default point is unique to the company being
evaluated and is determined by the company's liability structure and asset value.
FACTORS THAT DETERMINE THE DEFAULT PROBABILITY OF THE COMPANY
1. ASSET VALUATION
The market value of the company's assets is referred to as the value of assets. It is the amount of money
that an investor would pay to own the asset. In other words, the value of assets equals the current value
of the assets' future free cash flows, which are then discounted at the appropriate discount rate.

2. ASSET RISK
The asset risk is a measure of a company's business and industry risk. When determining the
value of assets, analysts calculate an estimate based on the fair market value of comparable
assets in the market.
There is a risk to the asset value because the value is uncertain, and businesses should measure
the asset value in the context of the asset risk.
3. LEVERAGE
When a company borrows money to invest in its operations, it is using leverage. Investors use
leverage to increase their market buying power and increase the returns on their investments.
Rather than issuing new shares to raise capital, some companies prefer to finance their
operations and increase shareholder value through debt.
Leverage is calculated by comparing the market value of assets to the book value of liabilities
that must be paid. When the market value of assets falls while the book value of liabilities rises,
the default risk rises.
When the book value of liabilities exceeds the market value of assets, it indicates that assets
are insufficient to meet future obligations.
ADVANTAGES OF KMV MODEL-
 Changes in EDF tend to occur at least one year before a downgrade of the issuer by rating
agencies such as Moody's and S & P's.
 EDF ranks credit quality on a cardinal rather than ordinal scale.
 Accurate and timely information from the equity market allows for continuous credit
monitoring, which is difficult and costly to replicate using traditional credit analysis.
 Annual reviews and other traditional credit processes cannot provide the same level of vigilance
that EDFs calculated monthly or daily can.

LIMITATIONS OF KMV MODEL-

 It necessitates some subjective estimation of the input parameters; and
 It generally requires some subjective estimation of the input parameters; and
 EDFs for private firms can only be calculated using some comparability analysis based on
accounting data.
 EDFs for private firms can only be calculated using some comparability analysis based on
accounting data.