Hi David...Request you to please clarify the following -

1) In Merton Model, one of the practical difficulty which hampers the empirical relevance of the Merton Model is “The estimation of asset volatility is difficult due to the low frequency of observation” - Pls. explain this statement.

2) In Chp.3 of De Servigny in KMV Model it says - “The estimation of the firm value process is also difficult: How should we estimate the drift and volatility of the asset value process when this value is unobservable.” - Cud you pls. explain this.

3) In Chpt.4 of De Servigny in regard to paper by Frye (2000a, 2000b), it says that PD&LGD;are negatively correlated. Shouldn’t it be PD & Recovery Rate instead?

Pls. help.

Regards
Sipani

Hi Sipani,

(1) and (2): these are from the same challenge. Because the KMV model has three big steps and the first step in the KMV is to apply the Merton model to solve for two unknowns: asset (firm) value and asset (firm) volatility. So these are the same difficulty, essentially.

Note for a public firm, we already have the stock price and the equity value (stock price * shares outstanding). But KMV *needs* asset (firm) value and asset (firm) volatility, where asset (firm) = equity + debt. As the debt probably is not exchanged-traded (without continuous price), it’s price is lumpy/model-based, so too with asset value. In practice, we often estimate firm (entity) value = market value of equity + book value of debt. But KMV, being precise, wants market value of debt, hence the challenge.

(3) I retrieved the source paper to check this. Fry 2000 (Depressing Recoveries, Chicago Fed): “According to the model, if the systematic risk factor pushes the default rate to a level of 10%, average recovery might fall to about 20%. This contrasts to the normal-year average of 45% or so.” In other words, you are correct! Several years has de Servigny been assigned and no one (including me) has noticed this typo. I love it, no wonder i have the highest pass rates: i have the best customers. It is my honor to be in the company of such detail orientation....

David