What is the distance to default (DD) defined as?

• A. The percentage difference between a firm's assets and its liabilities
• B. The number of standard deviations away from default
• C. The expected return on equity based on asset volatility
• D. The calculation of the face value of a firm's debt

Answer: (B)

Distance to default (DD) quantifies the likelihood that a firm will default on its obligations, typically measured in terms of how many standard deviations away the firm’s asset value is from the default threshold (often the value of liabilities). It incorporates both the volatility of the firm's asset value and its current financial situation. Essentially, if the asset value decreases significantly, the likelihood of default increases; thus, DD provides a numeric measure of that risk.

This concept is central to models like the Merton model, which estimates credit risk by modeling the firm's equity as a call option on its assets. When we say that a company has a DD of 2, for example, we are indicating that its asset value is 2 standard deviations above the default point. As a measure, DD is useful for investors and analysts to determine how secure a firm's financial position is, based on current asset levels and market conditions.

The other options do not encapsulate this concept accurately: the first choice refers to a calculation but not one that pertains directly to the statistical nature of DD, while the third focuses on expected returns, and the fourth is concerned with debt valuation rather than the risk of default itself.