KMV

KMV is a structural credit risk model originally developed by Kealhofer, McQuown and Vasicek in the late 1990s. It treats a firm as a levered asset whose value follows a stochastic process, and it estimates the firm’s probability of default (PD) from market information. The KMV approach was later commercialized by KMV LLC, which became part of Moody’s Analytics.

The core idea of KMV is that a company’s equity can be viewed as a call option on its assets with the strike equal to the value of the liabilities. By observing the market value and volatility of the firm’s equity, the model inverts the Black–Scholes–Merton framework to infer the current asset value (A0) and asset volatility (sigma_A). From these, it defines a default point (DP), typically based on short-term liabilities plus a portion of long-term debt, representing the asset level at which default would be triggered. The distance to default (DD) is then computed as DD = [ln(A0/DP) + (mu − 0.5 sigma_A^2) T] / (sigma_A sqrt(T)), where mu is the expected return of assets and T is the horizon. The probability of default is approximated by PD ≈ N(−DD), using the standard normal distribution.

Applications of KMV include credit risk assessment, portfolio risk measurement, and pricing of credit-sensitive instruments. It emphasizes market-implied solvency rather than accounting measures alone, and it has been influential in risk management and ratings. Limitations include sensitivity to the choice of default point, model assumptions about asset dynamics, and data requirements, particularly for non-public firms or illiquid equity. The model’s name has become a widely used label for the family of market-based, structural credit models associated with KMV’s methodology.