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Extending the Merton Model: A Hybrid Approach to Assessing Credit Quality

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Author Info
Alexandros Benos (University of Piraeus)
George Papanastasopoulos (University of Peloponnese)

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Abstract

In this paper we have combined fundamental analysis and contingent claim analysis into a hybrid model of credit risk measurement. We have extended the standard Merton approach to estimate a new risk neutral distance to default metric, assuming a more complex capital structure, adjusting for dividend payments, introducing randomness to the default point and allowing a fractional recovery when default occurs. Then, using financial ratios, other accounting based measures and the risk neutral distance metric from our structural model as explanatory variables we estimate the hybrid model with an ordered probit regression method. Using the same econometric method, we estimate a model using financial ratios and accounting variables as explanatory variables and a model using our risk neutral distance to default metric as unique explanatory variable.We have found that by enriching the risk-neutral distance to default metric with financial ratios and accounting variables into the hybrid model, we can improve both in sample fit of credit ratings and out of sample predictability of defaults. Our main conclusion is that financial ratios and accounting variables contain significant and incremental information, thus the risk neutral distance to default metric does not reflect all available information regarding the credit quality of a firm.

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Paper provided by EconWPA in its series Finance with number 0505020.

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Length: 34 pages
Date of creation: 27 May 2005
Date of revision: 03 Jun 2005
Handle: RePEc:wpa:wuwpfi:0505020

Note: Type of Document - pdf; pages: 34
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Web page: http://129.3.20.41

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Related research
Keywords: credit risk; distance to default; financial ratios; accounting variables;

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G - Financial Economics

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Franks, Julian R. & Torous, Walter N., 1994. "A comparison of financial recontracting in distressed exchanges and chapter 11 reorganizations," Journal of Financial Economics, Elsevier, vol. 35(3), pages 349-370, June. [Downloadable!] (restricted)
  2. Gordon Delianedis & Robert Geske, 2001. "The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors," University of California at Los Angeles, Anderson Graduate School of Management 1025, Anderson Graduate School of Management, UCLA. [Downloadable!]
  3. Marshall E. Blume & Felix Lim & A. Craig MacKinlay, . "The Declining Credit Quality of US Corporate Debt: Myth or Reality?," Rodney L. White Center for Financial Research Working Papers 3-98, Wharton School Rodney L. White Center for Financial Research.
  4. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July. [Downloadable!] (restricted)
    Other versions:
  5. Eberhart, Allan C & Moore, William T & Roenfeldt, Rodney L, 1990. " Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings," Journal of Finance, American Finance Association, vol. 45(5), pages 1457-69, December. [Downloadable!] (restricted)
  6. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March. [Downloadable!] (restricted)
  7. repec:fth:pennfi:67 is not listed on IDEAS
  8. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July. [Downloadable!] (restricted)
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    Other versions:
  10. Loretta J. Mester, 1997. "What's the point of credit scoring?," Business Review, Federal Reserve Bank of Philadelphia, issue Sep, pages 3-16. [Downloadable!]
  11. Cantor, Richard & Packer, Frank, 1997. "Differences of opinion and selection bias in the credit rating industry," Journal of Banking & Finance, Elsevier, vol. 21(10), pages 1395-1417, October. [Downloadable!] (restricted)
  12. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring. [Downloadable!] (restricted)
  13. Saikat Nandi, 1998. "Valuation models for default-risky securities: An overview," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 22-35. [Downloadable!]
  14. Marshall E. Blume & Felix Lim & A. Craig MacKinlay, . "The Declining Credit Quality of US Corporate Debt: Myth or Reality?," Rodney L. White Center for Financial Research Working Papers 03-98, Wharton School Rodney L. White Center for Financial Research.
  15. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  16. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(2), pages 481-523.
  17. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Papanastasopoulos, George, 2005. "Using Option Theory and Fundamentals to Assessing Default Risk of Listed Firms," MPRA Paper 453, University Library of Munich, Germany, revised Jun 2006. [Downloadable!]
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