The Relevance of Accounting Data in the Measurement of Credit Risk

Abstract

Option pricing theory provides a robust and theoretically sound framework for the measurement of credit risk. Assuming perfect market conditions, information relevant to the measurement of a firm’s credit risk is reflected in its equity price, with no role for accounting data. This hypothesis is tested using UK data and credit ratings as a proxy for credit risk. It is found that Merton’s distance-to-default measure is the most significant variable in the measurement of credit risk. However, it is also found that accounting variables are incrementally informative when added to a model that contains only the distance-to-default measure. The incremental informativeness of accounting data varies across industries and depends on firm size. Although it is found that the general level of credit risk depends on the state of the economy, there is no evidence to suggest that the incremental informativeness of the accounting variables depends upon macroeconomic conditions.

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