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Modeling Default Risk

by Peter J. Crosbie of Moody's|KMV, and
Jeffrey R. Bohn of Moody's|KMV

December 18, 2003

Abstract: Default risk is the uncertainty surrounding a firm's ability to service its debts and obligations. Prior to default, there is no way to discriminate unambiguously between firms that will default and those that won't. At best we can only make probabilistic assessments of the likelihood of default. As a result, firms generally pay a spread over the default-free rate of interest that is proportional to their default probability to compensate lenders for this uncertainty.

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