Recently, KMV has performed a simple analysis of the relationship of corporate bond pricingto.Expected Default Frequency as a measure of default probability, and a simulation of bond investment strategies based on the differences between actual and theoretical prices. While this work is by all criteria a preliminary effort, based on limited data and utilizing naïve methodology, the results are sufficiently encouraging to warrant further investigation. The findings are reported here.
The issue analyzed in the first part of the study is the extent to which the EDF is reflected in the market's pricing of bonds. Theoretically, a corporate bond price (plus accrued interest) should be equal to the present value of its cash flows discounted at rates that are the sum of the risk less discount rates plus the expected loss rate and a risk
