Answer: The expected default frequency would decrease to 0.3%

## Explanation This question compares the Merton model approach with the KMV (Moody's KMV) approach for estimating default probabilities. **Key Points:** 1. **Merton Model**: Uses a theoretical framework where default occurs when the firm's asset value falls below a certain threshold (in this case, short-term debt + half of long-term debt). The probability of default is calculated using the normal distribution function N(-DD), where DD is the distance-to-default. 2. **KMV Approach**: Uses historical default data to map distance-to-default values to actual observed default frequencies (EDF - Expected Default Frequency). 3. **Given Information**: - Merton model PD = 1.25% - N(-2.24) = 1.25% (meaning DD = 2.24 in Merton model) - KMV buckets show: - DD < -4: EDF = 0.3% - DD = -4 to -3: EDF = 0.3% 4. **Analysis**: - The firm's DD of 2.24 in Merton model doesn't fall into either of the provided KMV buckets (which are for negative DD values) - However, the question implies that with DD = 2.24, the KMV approach would assign a lower EDF than the theoretical 1.25% - The KMV buckets show much lower default frequencies (0.3%) for the given ranges 5. **Conclusion**: When switching from the theoretical Merton model to the empirical KMV approach, the expected default frequency would decrease from 1.25% to 0.3% based on the historical mapping provided. Therefore, the correct answer is **B** - The expected default frequency would decrease to 0.3%.

Author: LeetQuiz .