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Forecasting Default with the KMV-Merton Model

36 Pages Posted: 31 Dec 2004  

Sreedhar T. Bharath

Arizona State University - W.P. Carey School of Business

Tyler Shumway

University of Michigan at Ann Arbor, The Stephen M. Ross School of Business

Date Written: December 17, 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.

Keywords: Default, Merton Model

JEL Classification: G33

Suggested Citation

Bharath, Sreedhar T. and Shumway, Tyler, Forecasting Default with the KMV-Merton Model (December 17, 2004). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=637342 or http://dx.doi.org/10.2139/ssrn.637342

Sreedhar Bharath

Arizona State University - W.P. Carey School of Business ( email )

400 E. Lemon Street
Tempe, AZ 85287
United States
347-256-8784 (Phone)

Tyler Shumway (Contact Author)

University of Michigan at Ann Arbor, The Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-4129 (Phone)
734-936-0274 (Fax)

HOME PAGE: http://www.umich.edu/~shumway

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