CREDIT RESEARCH & RISK MEASUREMENT

EDF Overview
FROM MOODY’S ANALYTICS

MOODY’S ANALYTICS EDF™ (EXPECTED DEFAULT FREQUENCY) ASSET VOLATILITY

CREDIT MEASURES A measure of the business risk of the firm; technically, the standard
EDF stands for Expected Default Frequency and is a measure of the deviation of the annual percentage change in the market value of the
probability that a firm will default over a specified period of time firm’s assets. The higher the asset volatility, the less certain investors
(typically one year). “Default” is defined as failure to make scheduled are about the market value of the firm, and the more likely the firm’s
principal or interest payments. value will fall below its default point.
According to the Moody’s EDF model, a firm defaults when the
market value of its assets (the value of the ongoing business) falls DEFAULT POINT
below its liabilities payable (the default point). The level of the market value of a company’s assets, below which the
firm would fail to make scheduled debt payments. The default point
THE COMPONENTS OF EDF
is firm specific and is a function of the firm’s liability structure. It is
There are three key values that determine a firm’s EDF credit measure: estimated based on extensive empirical research by Moody’s Analyt-
»» The current market value of the firm (market value of assets) ics, which has looked at thousands of defaulting firms, observing
each firm’s default point in relation to the market value of its assets
»» The level of the firm’s obligations (default point)
at the time of default.
»» The vulnerability of the market value to large changes
(asset volatility)
Because these are objective, non-judgmental variables, EDF credit Default
DefaultProcess
Processininthe
theStructural
StructuralModel
Model
measures have consistently outperformed the rating agencies in Value of Assets / Liabilities
Distribution of market
distinguishing between defaulting and non-defaulting firms. Not value of assets

only that, they have proven to be a consistent leading indicator of Asset Volatility
agency rating upgrades and downgrades. Distance to default
σ (DD) in σ

MARKET VALUE OF ASSETS E[AT] = μ

The market’s view of the enterprise value of the firm, as determined

by the firm’s equity value, equity volatility, and liability structure.
XT
Because the market value of assets is not directly observable, Moody’s
Analytics employs a proprietary option-theoretic model to compute Notional value of liabilities
PD ≈ EDFTM
this value, which treats the firm’s equity value as a call option on the
firm’s underlying assets. t=0 T = 1 year Time

The option-theoretic approach enables Moody’s Analytics to

1
determine the market value of a firm’s assets from knowing only
the market characteristics of its equity value and the book value
of its liabilities.
Credit Research & Risk Measurement

THE EDF DIFFERENCE

Median Moody's EDF in US
Moody’s EDF credit measures exhibit a number of characteristics that Size $30 million and above
Jan '05 - Sept '10
distinguish them from conventional and other statistical approaches 3.00%
to measuring default risk. Moody's EDF

»» EDF credit measures are a dynamic and forward-looking measure, 2.50%

unlike alternatives that generally rely on accounting data that is
intrinsically historical and backward-looking.
2.00%
»» EDF credit measures are actual probabilities critical in debt

EDF Measure (%)

pricing and portfolio management applications, in contrast with 1.50%
alternative products that offer only relative rankings.
»» The EDF credit measure is based on a cause-and-effect model 1.00%
that is not statistically fitted to predict default. This results in
performance that is consistent over time. In contrast, the same
0.50%
agency bond rating corresponds to different default rates at
different times.
0.00%
Because Moody’s EDF credit measures are not fitted to predict Jan05 Jan06 Jan07 Jan08 Jan09 Jan10

default, they can be accurately back-tested upon historical data.

Moody’s EDF credit measures have been tested on nearly 35 years Median Moody's EDF in Europe
of data representing approximately 5,300 defaults in the United Size $30 million and above
Jan '05 - Sept '10
States alone, as well as on smaller samples in various countries 3.00%
Moody's EDF
around the globe.
2.50%
Moody’s EDF credit measures significantly outperforms agency
ratings in measuring the probability of default, as well as statistical
2.00%
scoring models of all types.
EDF Measure (%)

1.50%

1.00%

0.50%

0.00%
Jan05 Jan06 Jan07 Jan08 Jan09 Jan10

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