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Related Research
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Moody's KMV utilizes a structural approach to value credit instruments and to model credit spreads. Our research shows that the structural framework produces intuitive, robust, and easy-to-interpret estimates. Our credit spread framework act as a bridge across multiple markets when valuing credit instruments, utilizing information from a variety of sources, including: equities, bonds, and CDS. Users can triangulate information from these markets, enabling a more comprehensive and in-depth understanding of credit spread drivers and identification of relative value opportunities.
Our research indicates that credit spreads reflect both credit and non-credit-related components. The credit component includes default and recovery risk, as well as investors' required premium for undertaking credit risk. Employing a risk-neutral pricing framework, our approach converts EDF credit measures, MKMV's measure of physical default probability, into a risk-neutral default probability. The risk-neutral default probability is a function of the EDF credit measure, instrument's term, the market Sharpe ratio (market's required return for bearing credit risk), and the correlation of the firm issuing the instrument with the overall economy. The resulting risk-neutral default probabilistic, combined with estimate of expected recovery and instrument's terms, serves as the building blocks for modeling credit spreads. To ensure that estimates are accurate, data from various sources are carefully analyzed and cleaned using a variety of filters to identify the most likely transacted prices, rather than matrixed or estimated prices. Data is subjected further to a battery of additional consistency checks before model estimation.
MKMV produces daily estimates for the factors driving credit spreads. We provide users with EDF credit measures, market Sharpe ratio, implied Loss Given Default (LGD), and size premium, which reflects the non-credit component. In addition to providing the EDF-implied spread, we also provide fair value credit spreads for bonds and CDS. All this information, combined with option adjusted bond spreads from other data providers, is delivered via our intuitive web-based applications: CreditEdge®, CreditEdge Plus, and CreditMark®. These platforms provide a powerful and versatile toolset that helps identify relative value opportunities, form opinions on credit spreads, and identify factors driving market-wide spreads as well as firm-specific spreads. These applications can perform analyses on a select portfolio, calculating how spreads react to changes in model parameters, model assumptions, and firm-specific financial information.
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