Estimating Default Probabilities Implicit in Equity Prices

Abstract

This paper uses a reduced-form credit risk model to estimate default probabilities implicit in equity prices. For a cross-section of firms, a time-series regression of monthly equity returns is estimated. We show that it is feasible to infer the firm's probability of default implicit in equity returns. However, the existence of price bubbles and the difficulty in modeling equity price risk premium confound the estimation of these default probabilities, generating potentially biased estimates with large standard errors. Comparing these default intensities with those obtained from historical data or implicitly from debt prices confirms this result.

Study on Default Risk Based on LT Model: Evidence from Chinese List Companies

“…①Estimated EDF of special treated company is 13.04% (t=1). Compared with the internationally highest default rate provided by Appraisal Company, such as Standard and Pool is 19.79% and KMV is 20% [12]. As a result, default rate of the sample companies in the study is relatively high, which means the credit risk of our national stock market is comparatively high.…”

The Anatomy of Distressed Debt Markets

“…Related to the distressed, but not defaulted, debt strategy is the ability to forecast whether the firm will go bankrupt. Such techniques as our Z-score models; the Kamakura (Van Dementer 2012) and Janosi, Jarrow & Yildirim (2003) reduced-form models based primarily on equity prices and volatility, such as KMV's (now Moody's) expected default frequency model; or perhaps other failure prediction methods could be used to assess default probability. The prospect of an increase of value from a distressed state to par value in a relatively short period of time (e.g., 6-12 months) has been achieved in many cases by both active and passive investors or outsized returns on securities of firms already in bankruptcy.…”