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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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    File URL: http://128.118.178.162/eps/fin/papers/0505/0505020.pdf
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    Bibliographic Info

    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://128.118.178.162

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

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    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.
    2. 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.
    3. 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.
    4. 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.
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    6. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
    7. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 541-552, November.
    8. 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.
    9. Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
    10. Engelmann, Bernd & Hayden, Evelyn & Tasche, Dirk, 2003. "Measuring the Discriminative Power of Rating Systems," Discussion Paper Series 2: Banking and Financial Studies 2003,01, Deutsche Bundesbank, Research Centre.
    11. Merxe Tudela & Garry Young, 2003. "A Merton-model approach to assessing the default risk of UK public companies," Bank of England working papers 194, Bank of England.
    12. 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.
    13. 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.
    14. Loretta J. Mester, 1997. "What's the point of credit scoring?," Business Review, Federal Reserve Bank of Philadelphia, issue Sep, pages 3-16.
    15. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04.
    16. Delianedis, Gordon & Geske, Robert, 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 qt32x284q3, Anderson Graduate School of Management, UCLA.
    17. Saikat Nandi, 1998. "Valuation models for default-risky securities: An overview," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 22-35.
    18. repec:fth:pennfi:67 is not listed on IDEAS
    19. 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.
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    Cited by:
    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.

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