Predictions of Default Probabilities by Models with Dynamic Leverage Ratios

30 Pages Posted: 28 Mar 2008

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

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

H. C. Lee

Department of Physics

Date Written: March 23, 2007

Abstract

This paper examines the term structures of default probabilities that are generated by the Collin-Dufresne and Goldstein model and a dynamic-leverage-ratio model. The dynamic-leverage-ratio model is capable of producing term structures of default probabilities which are consistent with some empirical observed default rates. It demonstrates that the leverage ratio is a determinant factor of default risk of firms. The Collin-Dufresne and Goldstein model which considers a leverage ratio mean- reverting towards a constant target leverage ratio however gives default probabilities lower than the empirical observed default rates. The predicted default probabilities of the models are sensitive to the dynamics of the leverage ratio, in particular the mean-reverting property of the leverage ratio towards a constant target leverage ratio.

Keywords: Credit Risk Models, Credit Ratings, Default Probability

JEL Classification: G21, G28, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Huang, Ming-Xi and Lee, H. C., Predictions of Default Probabilities by Models with Dynamic Leverage Ratios (March 23, 2007). Available at SSRN: https://ssrn.com/abstract=1113726 or http://dx.doi.org/10.2139/ssrn.1113726

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

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

H. C. Lee

Department of Physics ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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