Forecasting Default with the KMV-Merton Model

Sreedhar T Bharath and Tyler Shumway
December, 2004

Abstract

We examine the accuracy and contribution of the default forecasting model based on Merton's (1974) bond pricing model and developed by the KMV corporation. Comparing the KMV-Merton model to a similar but much simpler alternative, we find that it performs slightly worse as a predictor in hazard models and in out of sample forecasts. Moreover, several other forecasting variables are also important predictors, and fitted hazard model values outperform KMV-Merton default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with KMV-Merton default probabilities after adjusting for agency ratings, bond characteristics, and our alternative predictor. We conclude that the KMV-Merton model does not produce a sufficient statistic for the probability of default, and it appears to be possible to construct such a sufficient statistic without solving the simultaneous nonlinear equations required by the KMV-Merton model.

We include the SAS code we use to calculate KMV-Merton default probabilities in an appendix.

A full-text version of this paper in Adobe Acrobat (pdf) format is available for downloading here.

The SAS code used to calculate iterate KMV-Merton default probabilities (using the algorithm applied in the paper) can be downloaded here.




Tyler Shumway
shumway@umich.edu
http://www-personal.umich.edu/~shumway/