A model is simply a tool
Bankers and investors putting on debt versus equity trades are drawing on the idea first expounded by Nobel economics laureate Robert Merton that equity can be thought of as a call option on the assets of a firm. If the share price dips below a certain level - implying a lower value on the firm's assets and cashflows relative to its liabilities - default will follow. Bondholders, meanwhile, have sold an equity put option to the issuer and the spread on a corporate bond is the premium for taking that position.
KMV has popularized this theory over the past 10 years with its model providing - for a fee - an estimated default frequency (EDF) measure for corporates based on its proprietary database of historical default data. So the market was already attuned to this idea when CreditGrades - by Riskmetrics, with the backing of Goldman Sachs, JPMorgan and Deutsche Bank - was launched in June.
According to Jorge Mina, head of risk modelling at Riskmetrics, CreditGrades improve on KMV both in terms of being more transparent and more user-friendly. "The big difference is that certain parts of KMV, such as the historical database of default probabilities, are not market observable," he says.