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Incorporating the Dynamics of Leverage into Default Prediction

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Author Info
Gunter Löffler
Alina Maurer
Abstract

A firm’s current leverage ratio is one of the core characteristics of credit quality used in statistical default prediction models. Based on the capital structure literature, which shows that leverage is mean-reverting to a target leverage, we forecast future leverage ratios and include them in the set of default risk drivers. The analysis is done with a discrete duration model. Out-of-sample analysis of default events two to five years ahead reveals that the discriminating power of the duration model increases substantially when leverage forecasts are included. We further document that credit ratings contain information beyond the one contained in standard variables but that this information is unrelated to forecasts of leverage ratios.

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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2009-024.

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Length: 28 pages
Date of creation: Apr 2009
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Handle: RePEc:hum:wpaper:sfb649dp2009-024

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Related research
Keywords: default prediction; discrete duration model; leverage targeting; mean reversion; credit rating;

Find related papers by JEL classification:
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

This paper has been announced in the following NEP Reports:

References listed on IDEAS
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