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Performance of default risk model with barrier option framework and maximum likelihood estimation: Evidence from Taiwan

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  • Chou, Heng-Chih
  • Wang, David
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    Abstract

    We investigate the performance of a default risk model based on the barrier option framework with maximum likelihood estimation. We provide empirical validation of the model by showing that implied default barriers are statistically significant for a sample of construction firms in Taiwan over the period 1994–2004. We find that our model dominates the commonly adopted models, Merton model, Z-score model and ZETA model. Moreover, we test the n-year-ahead prediction performance of the model and find evidence that the prediction accuracy of the model improves as the forecast horizon decreases. Finally, we assess the effect of estimated default risk on equity returns and find that default risk is able to explain equity returns and that default risk is a variable worth considering in asset-pricing tests, above and beyond size and book-to-market.

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    Bibliographic Info

    Article provided by Elsevier in its journal Physica A: Statistical Mechanics and its Applications.

    Volume (Year): 385 (2007)
    Issue (Month): 1 ()
    Pages: 270-280

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    Handle: RePEc:eee:phsmap:v:385:y:2007:i:1:p:270-280

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    Web page: http://www.journals.elsevier.com/physica-a-statistical-mechpplications/

    Related research

    Keywords: Default risk model; Barrier option framework; Default prediction; Maximum likelihood estimation;

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    Cited by:
    1. Lin, Jyh-Horng & Tsai, Jeng-Yan & Hung, Wei-Ming, 2014. "Bank equity risk under bailout programs of loan guarantee and/or equity capital injection," International Review of Economics & Finance, Elsevier, vol. 31(C), pages 263-274.
    2. Chang, Chuen-Ping, 2012. "Default probability of a captive credit bank with government capital injections: A capped barrier option approach," Economic Modelling, Elsevier, vol. 29(6), pages 2444-2450.
    3. Chen, Dar-Hsin & Chou, Heng-Chih & Wang, David & Zaabar, Rim, 2011. "The predictive performance of a path-dependent exotic-option credit risk model in the emerging market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(11), pages 1973-1981.
    4. Lin, Jyh-Horng & Hung, Wei-Ming, 2013. "A barrier option framework for bank interest margin management under anticipatory regret aversion," Economic Modelling, Elsevier, vol. 33(C), pages 794-801.

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