The number of standard deviations by which a firm's asset value sits above its default threshold. A smaller distance means a higher chance of default.
Where you will meet it
Distance to default comes up in 5 learning outcome notes across the FRM syllabus.
A few of them:
External and Internal Credit Ratings FRM Part I · Valuation and risk models
“Equity-based structural models, in the Merton tradition, treat equity as a call option on the firm's assets and use equity value, equity volatility and debt to estimate distance to default.”
Introduction to Credit Risk Modeling and Assessment FRM Part II · Credit risk measurement and management
“Distance to default is the number of standard deviations the log asset value sits above the default point.”
Introduction to Credit Risk Modeling and Assessment FRM Part II · Credit risk measurement and management
“It infers asset value and volatility from equity and computes distance to default against a default point of short-term liabilities plus half of long-term liabilities.”
Estimating Default Probabilities FRM Part II · Credit risk measurement and management
“Distance to default is the number of standard deviations by which the expected log asset value exceeds the default point: DD = (ln(V0 ÷ D) + (μ − σ²÷2) × T) ÷ (σ × √T).”
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