This is part of a Moody’s document, Modeling Credit Portfolios, explanining RiskFrontier methodology.

A primary source of risk in a credit portfolio is the probability of default (PD) of obligors in the portfolio. A firm defaults when it fails to make schedule principal or interest payments. In other words, a firm defaults when the market value of its assets (i.e., the value of its ongoing business) falls below its liabilities payable (i.e., the firm’s default point). Traditional approaches for measuring default probabilitiy involve a detailed examination of a company’s operations to project current and future cash flows of the firm. Other estimation methods, such as those used by Moody’s Analytics, rely on observable market prices, such as trade equity and traded debt to determine an implied-default probability.

Moody’s Analytics has found that equity markets are better sources of information than debt markets. The liquidity of equity markets makes them better sources of data than the opaque dealer markets used to trade debt. Moreover, continuous transaction histories are available for companies listed all over the world, facilitating global coverage. Consequently, Moody’s Analytics estimates default probabilities from equity prices, producing EDF (Expected Default Frequency) credit measures for most publicly traded firms. Moreover, the framework is extended to produce EDF measures for private firms by using information from similar firms with traded equity.