Distance to default
Quantitative Finance glossary · Quantitative Finance
Definition
Structural-credit metric from Merton's model: DD = dfracln(V/D) + (μ_V - 1/2σ_V^2)Tσ_V√(T), the number of standard deviations the asset value V is above the debt level D at horizon T. Risk-neutral default probability is N(-DD). KMV (now Moody's Analytics) commercialised the model, calibrating asset value and vol from equity price via the option-pricing identity E = V,N(d_1) - D,e^-rTN(d_2). The benchmark structural credit measure.
Distance to default in plain English
This is a way to measure how close a company is to going bankrupt, and the intuition is that a firm defaults when the total value of what it owns falls below what it owes. Distance to default counts how many "bad-luck standard deviations" of a drop it would take to get there — so a distance of 4 means the company's assets would have to fall unusually far before creditors aren't paid, while a distance of 1 means it's dangerously close. Think of it as sea level: how many big waves would have to hit before the water tops your seawall? The neat twist is that you can back out the firm's hidden asset value and shakiness from its publicly traded stock price, and a bigger distance translates directly into a smaller probability of default. It's the benchmark for this style of credit risk, made famous commercially by KMV (now Moody's Analytics).
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