Does Using Time-Varying Target Leverage Ratios in Structural Credit Risk Models Improve Their Accuracy?

Journal of Risk Model Validation, Volume 6/Number 3, page 27-49, 2012

24 Pages Posted: 7 Mar 2008 Last revised: 5 Oct 2012

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

T. C. Wong

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

M. X. Huang

Chinese University of Hong Kong - Department of Physics and Institute of Theoretical Physics

Date Written: October 5, 2012

Abstract

Empirical findings and theoretical studies suggest that firms adjust toward time-varying target leverage ratios. This paper studies the performances of the default probabilities generated from two structural credit risk models (one with time-dependent leverage ratios and one with constant target leverage ratios) and credit ratings. The time-dependent model consistently performs better than the other model and credit ratings in terms of having the discriminatory power to differentiate firms’ default risk and the capability to predict default rates over the period from 1996 to 2006. The material differences between the predictive capability of the two models show that the time dependency of the target leverage ratio is a critical factor in modeling credit risk. The study also provides evidence to support the existence of a time-varying target leverage ratio.

Keywords: Leverage, Default probabilities, Credit risk

JEL Classification: C60, G13, G32

Suggested Citation

Hui, Cho-Hoi and Wong, Tak-Chuen and Lo, Chi-Fai and Huang, Ming-Xi, Does Using Time-Varying Target Leverage Ratios in Structural Credit Risk Models Improve Their Accuracy? (October 5, 2012). Journal of Risk Model Validation, Volume 6/Number 3, page 27-49, 2012. Available at SSRN: https://ssrn.com/abstract=1101983 or http://dx.doi.org/10.2139/ssrn.1101983

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Tak-Chuen Wong

Hong Kong Monetary Authority - Research Department ( email )

55/F, Two International Finance Centre,
8 Finance Street, Central,
Hong Kong
Hong Kong

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Ming-Xi Huang

Chinese University of Hong Kong - Department of Physics and Institute of Theoretical Physics ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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