Estimation of Probability of Default Using Merton's Option Pricing Approach: An Empirical Analysis

Abstract

The Basel II accord emphasizes risk sensitiveness for the capital of commercial banks. It recommends two methods, standardized approach and internal rating based (IRB) approach, for the estimation of risk capital requirements. Whereas, the former approach is based on external credit ratings, the latter uses estimates of probability of default (PD). This study employs the Merton' Option Pricing Model to estimate the PDs for firms in India, in order to assess the appropriateness of these approaches for risk capital estimation. We estimate the PDs on a sample of sixty seven Indian firms during the period 1998-2004. It finds that the credit ratings accorded by Indian agencies have poor discriminating power in terms of its PDs. This finding suggests that the credit ratings may not accurately lead to a correct assessment of risk capital requirement as prescribed under the standardized approach. Further, as the yearly PDs for firms do not show any significant pattern and exhibits high volatility, the estimates of capital requirement, would also be highly volatile under the IRB approach. Either it will be underestimated or overestimated. However, the results of the study are only tentative as the PDs estimated using the Merton's model are highly influenced by the volatility in the equity prices which is not necessarily connected to the probability of default.

Keywords: Basel II, Probability of default, option pricing, risk capital, credit rating