Hi David,

Hope you are not bugged by my stupid questions

yesterday while going through your notes and core readings i got through this:

ESTIMATE MARKET VALUE AND VOLATILITY OF FIRM: Given the market value and volatility of the firm’s stock and the book value of its liabilities; the market value and volatility of the firm are estimated.how volatility can be calculated?

core readings was saying that firm volatility calculation is propriety of KMV.in your notes you mentioned formula for calculating firm volatility through equity volatility.are both the same??

Anil

Hi Anil,

(please: you are never bugging me!)

This refers to (Moody) KMV’s EDF approach, which uses Merton Model (de Servigny Chapter 3) partly but not entirely. So, the first step in KMV is: TO ESTIMATE MARKET VALUE AND VOLATILITY OF FIRM (because the 2nd step is to compute distance to default).

For a typical public company, it is easy to get the equity capitalization (stock price * number of shares) and to measure equity (stock) volatility. But, instead, this first step wants the ASSET (a.k.a., ENTITY) market value and ASSET volatility.

IMO, this step is NON-TRIVIAL but also not proprietary (we know how they do it); the more “proprietary” step is how KMV maps a DD to an EDF/PD.  In this first step, KMV uses option pricing to simultaneously solve for ASSET value and volatility:

asset value = F[equity value, equity volatility, etc ]
asset volatility = F[equity value, equity volatility, etc etc]

It’s option based because, if you take just the first one, it’s “reverse engineering” the Black-Scholes where ASSET VALUE = Stock price, and equity value = call option price

equity (call option price) = Black-Scholes F[asset value(stock price), strike, volatility, riskless rate, div, term]

So, in regard to this first KMV step (finding asset vol and value):
* for the exam, we certainly don’t need to know *how* to do it
* Rather, just see how conceptually these are the NECESSARY INPUTS into the Merton approach to computing DD
* IMO, this first step is non-trivial and non-proprietary, but this view isn’t particularly important

David

Thanks David