Forecasting Corporate Bankruptcy: Optimizing the Performance of the Mixed Logit Model

In recent studies, Jones and Hensher (2004, 2005) provide an illustration of the usefulness of advanced probability modelling in the prediction of corporate bankruptcies, insolvencies and takeovers. Mixed logit (or random parameter logit) is the most general of these models and appears to have the greatest promise in terms of underlying behavioural realism, desirable econometric properties and overall predictive performance. It suggests a number of empirical considerations relevant to harnessing the maximum potential from this new model (as well as avoiding some of the more obvious pitfalls associated with its use). Using a three‐state failure model, the unconditional triangular distribution for random parameters offers the best population‐level predictive performance on a hold‐out sample. Further, the optimal performance for a mixed logit model arises when a weighted exogenous sample maximum likelihood (WESML) technique is applied in model estimation. Finally, we suggest an approach for testing the stability of mixed logit models by re‐estimating a selected model using varying numbers of Halton intelligent draws. Our results have broad application to users seeking to apply more accurate and reliable forecasting methodologies to explain and predict sources of firm financial distress better.