Forecasting Default with the Merton Distance to Default Model

Bharath, Sreedhar T.; Shumway, Tyler

doi:10.1093/rfs/hhn044

Cited by 1,730 publications

(1,213 citation statements)

References 15 publications

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“…Since firm asset values are not directly observable, we follow Bharath and Shumway (2008) and back out asset betas from equity betas based on the Merton (1974) model. Equity betas are computed using past 36 months of equity returns and value-weighted market returns 12 .…”

Section: Datamentioning

confidence: 99%

Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

Chen¹,

Yang

2012

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We build a dynamic capital structure model to study the link between firms' systematic risk exposures and their time-varying debt maturity choices, as well as its implications for the term structure of credit spreads. Compared to short-term debt, long-term debt helps reduce rollover risks, but its illiquidity raises the costs of financing. With both default risk and liquidity costs changing over the business cycle, our calibrated model implies that debt maturity is pro-cyclical, firms with high systematic risk favor longer debt maturity, and that these firms will have more stable maturity structures over the cycle. Moreover, pro-cyclical maturity variation can significantly amplify the impact of aggregate shocks on the term structure of credit spreads, especially for firms with high beta, high leverage, or a lumpy maturity structure. We provide empirical evidence for the model predictions on both debt maturity and credit spreads.

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Section: Datamentioning

confidence: 99%

Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

Chen¹,

Yang

2012

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“…However, the market leverage moves up and down far too much for equation (2) to provide reasonable estimates. To solve this problem, we follow Bharath and Shumway (2008) by implementing an iterative procedure. First, we choose a…”

Section: The Merton Distance-to-default Modelmentioning

confidence: 99%

“…Moody's KMV entertains some version of the Merton (1974) Bharath and Shumway (2008) compare estimated volatilities and default probabilities of 80 companies with these numbers. The rank correlation between their estimates and Moody's is 80% for the default probabilities and 57% for the volatilities, respectively.…”

Section: Data Setmentioning

confidence: 99%

Are Ratings the Worst Form of Credit Assessment Apart from All the Others?

Bloechlinger

Leippold

2012

SSRN Journal

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We present a prediction model to forecast corporate defaults. In a theoretical model, under incomplete information in a market with publicly traded equity, we show that our approach must outperform ratings, Altman's Z-score, and Merton's distance to default. We reconcile the statistical and structural approaches under a common framework, i.e., our approach nests Altman's and Merton's approaches as special cases. Empirically, we cannot reject the superiority of our approach.Furthermore, the numbers of observed defaults align well with the estimated probabilities. Finally, with rank transforms, we obtain cycle-adjusted forecasts that still outperform ratings. AbstractEnding the dependence on rating agencies is a top priority for the Financial Stability Board, which coordinates the G20 financial policies. Rating agencies have been accused of contributing to the recent financial crisis by misjudging the creditworthiness of mortgage-backed securities. Their downgrading practice of sovereigns and corporations is said to amplify procyclicality and to fuel market uncertainty. However, it is one thing to criticize rating agencies, quite another to find an appropriate alternative. For the case of corporate issuer ratings, we show that there is at least one such alternative. From a statistical viewpoint, it outperforms credit ratings. From a practical viewpoint, it is straightforward to implement and depends solely on publicly available data. Therefore, we conclude that for the case of corporate credit risk, appropriate alternatives to credit ratings do exist! JEL Classification Codes: G01, G18, G24

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“…can be computed using an iterative procedure suggested by Vassalou and Xing (2004) and Bharath and Shumway (2008). Here NðÁÞ is the standard normal distribution function, V the market value of the firm's assets, B the face value of the firm's debt, l the expected continuously compounded return on V, r V the volatility of firm's value, and T the maturing period of the firm's debt.…”

Section: Merton Modelmentioning

confidence: 99%

“…Here NðÁÞ is the standard normal distribution function, V the market value of the firm's assets, B the face value of the firm's debt, l the expected continuously compounded return on V, r V the volatility of firm's value, and T the maturing period of the firm's debt. The formulation of PB-Merton in (6) has been given in (7) of Bharath and Shumway (2008).…”

Section: Merton Modelmentioning

confidence: 99%

Assessing bankruptcy prediction models via information content of technical inefficiency

et al. 2011

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We use a stochastic frontier model with firmspecific technical inefficiency effects in a panel framework (Battese and Coelli in Empir Econ 20:325-332, 1995) to assess two popular probability of bankruptcy (PB) measures based on Merton model (Merton in J Financ 29:449-470, 1974) and discrete-time hazard model (DHM; Shumway in J Bus 74: 2001). Three important results based on our empirical studies are obtained. First, a firm with a higher PB generally has less technical efficiency. Second, for an ex-post bankrupt firm, its PB tends to increase and its technical efficiency of production tends to decrease, as the time to its bankruptcy draws near. Finally, the information content about firm's technical inefficiency provided by PB based on DHM is significantly more than that based on Merton model. By the last result and the fact that economic-based efficiency measures are reasonable indicators of the long-term health and prospects of firms (Baek and Pagán in Q J Bus Econ 41:27-41, 2002), we conclude that PB based on DHM is a better credit risk proxy of firms.

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Forecasting Default with the Merton Distance to Default Model

Cited by 1,730 publications

References 15 publications

Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

Are Ratings the Worst Form of Credit Assessment Apart from All the Others?

Assessing bankruptcy prediction models via information content of technical inefficiency

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