Estimating Expected Default Frequency (EDF) for Bonds

Very Hard Credit Analysis And Valuation Credit Risk Measurement

In an increasingly complex financial landscape, an investor is assessing the creditworthiness of a company's bonds. The company operates in a highly cyclical industry and has recently experienced a downturn due to economic conditions. During this period, the investor seeks to evaluate the risk of default. They discover that the company has a long history of variable cash flows, which have recently become more volatile due to rising interest rates and declining sales. The investor wants to calculate the company’s Expected Default Frequency (EDF) as part of their credit risk measurement.

Given the current financial scenario, which of the following approaches would be the most appropriate for this investor to estimate the EDF for the company's bonds?

Using historical bond rating transitions and the current corporate bond spreads to estimate the transition matrix.

Calculating the probability of default based on equity market performance and firm-specific systemic risk factors.

Applying a structural credit risk model that incorporates asset value volatility and the firm's leverage.

Hint

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