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http://ssrn.com/abstract=637342
 
 

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Forecasting Default with the KMV-Merton Model


Sreedhar T. Bharath


Arizona State University - W.P. Carey School of Business

Tyler Shumway


University of Michigan at Ann Arbor, The Stephen M. Ross School of Business

December 17, 2004

AFA 2006 Boston Meetings Paper

Abstract:     
We examine the accuracy and contribution of the default forecasting model based on Merton's (1974) bond pricing model and developed by the KMV corporation. Comparing the KMV-Merton model to a similar but much simpler alternative, we find that it performs slightly worse as a predictor in hazard models and in out of sample forecasts. Moreover, several other forecasting variables are also important predictors, and fitted hazard model values outperform KMV-Merton default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with KMV-Merton default probabilities after adjusting for agency ratings, bond characteristics, and our alternative predictor. We conclude that the KMV-Merton model does not produce a sufficient statistic for the probability of default, and it appears to be possible to construct such a sufficient statistic without solving the simultaneous nonlinear equations required by the KMV-Merton model.

We include the SAS code we use to calculate KMV-Merton default probabilities in an appendix.

Number of Pages in PDF File: 36

Keywords: Default, Merton Model

JEL Classification: G33

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Date posted: December 31, 2004  

Suggested Citation

Bharath, Sreedhar T. and Shumway, Tyler, Forecasting Default with the KMV-Merton Model (December 17, 2004). AFA 2006 Boston Meetings Paper. Available at SSRN: http://ssrn.com/abstract=637342 or http://dx.doi.org/10.2139/ssrn.637342

Contact Information

Sreedhar T. Bharath
Arizona State University - W.P. Carey School of Business ( email )
400 E. Lemon Street
Tempe, AZ 85287
United States
347-256-8784 (Phone)
Tyler Shumway (Contact Author)
University of Michigan at Ann Arbor, The Stephen M. Ross School of Business ( email )
701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-4129 (Phone)
734-936-0274 (Fax)
HOME PAGE: http://www.umich.edu/~shumway
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