The COSO Framework for Internal Control
February 12, 2025
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The expected default frequency (EDF) model is widely used across the world in order to effectively manage credit risk. In the previous article, we understood the basics of how this model works. However, in this article, we will have a closer look at the advantages and disadvantages of this model. The idea is to enable the user to weigh the pros and cons and make an informed decision.
There are several advantages of using the expected default frequency (EDF) model. Some of them have been listed below:
Despite all its advantages, the expected default frequency (EDF) model also has some serious shortcomings. Some of these have been explained below:
Hence, the results given by the model cannot be applied to reality straight away either. For instance, there is an assumption made that the returns offered by the market always follow a normal distribution. However, this is not the case. Also, the model assumes that all debt has to be paid back on the same date. This assumption is also an incorrect representation of reality.
Hence, it can be said that the expected default frequency (EDF) model is only useful while evaluating the credit of a handful of public companies. It cannot be used for small and medium enterprises which form the vast majority of business organizations in the world.
There can be short-term or long-term debt. Some of these debts are secured by collateral whereas others aren’t. However, the expected default frequency (EDF) model does not differentiate between them. This is because the expected default frequency (EDF) model predicts the possibility that the firm will default. Now, even if a firm defaults, it is possible that it will still pay out its priority creditors in full and only the lower order creditors will lose their money. This hierarchy of debt is not considered in the expected default frequency (EDF) model.
Hence, it would be fair to say that the expected default frequency (EDF) model is a high accuracy model. However, it has limited applications because of the shortcomings which have been mentioned above. However, it can be very useful while dealing with companies that are listed on public exchanges.
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