Article2007

Assessing credit quality from the equity market: can a structural approach forecast credit ratings?

34 citations0/0 files storedCanadian Journal of Administrative Sciences / Revue Canadienne des Sciences de l Administration

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Credit Risk and Financial Regulations Corporate Insolvency and Governance Financial Distress and Bankruptcy Prediction

Abstract

Abstract We investigate the empirical performance of default probability prediction based on Merton's (1974) structural credit risk model. More specifically, we study if distance‐to‐default is a sufficient statistic for the equity market information concerning the credit quality of the debt‐issuing firm. We show that a simple reduced form model outperforms the Merton (1974) model for both in‐sample fitting and out‐of‐sample predictability for credit ratings, and that both can be greatly improved by including the firm's equity value as an additional variable. Moreover, the empirical performance of this hybrid model is very similar to that of the simple reduced form model. As a result, we conclude that distant‐to‐default alone does not adequately capture the firm's credit quality information from the equity market. Copyright © 2007 ASAC. Published by John Wiley & Sons, Ltd.

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References

1974ON THE PRICING OF CORPORATE DEBT: THE RISK STRUCTURE OF INTEREST RATES*1996Multifactor Explanations of Asset Pricing Anomalies 1980Financial Ratios and the Probabilistic Prediction of Bankruptcy 2001Forecasting Bankruptcy More Accurately: A Simple Hazard Model 1995A Simple Approach to Valuing Risky Fixed and Floating Rate Debt 2004Default Risk in Equity Returns 1996Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads 1998Agency Costs, Risk Management, and Capital Structure

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