Forecasting Default with the Merton Distance to Default Model

Posted: 2 Jul 2008

See all articles by Sreedhar T. Bharath

Sreedhar T. Bharath

Arizona State University (ASU) - Finance Department

Tyler Shumway

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

Date Written: May 2008

Abstract

We examine the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model. We compare the model to a naïve alternative, which uses the functional form suggested by the Merton model but does not solve the model for an implied probability of default. We find that the naïve predictor performs slightly better in hazard models and in out-of-sample forecasts than both the Merton DD model and a reduced-form model that uses the same inputs. Several other forecasting variables are also important predictors, and fitted values from an expanded hazard model outperform Merton DD default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with Merton DD probabilities after adjusting for agency ratings and bond characteristics. We conclude that while the Merton DD model does not produce a sufficient statistic for the probability of default, its functional form is useful for forecasting defaults.

Keywords: G12, G13, G33

Suggested Citation

Bharath, Sreedhar T. and Shumway, Tyler, Forecasting Default with the Merton Distance to Default Model (May 2008). The Review of Financial Studies, Vol. 21, Issue 3, pp. 1339-1369, 2008. Available at SSRN: https://ssrn.com/abstract=1154435 or http://dx.doi.org/hhn044

Sreedhar T. Bharath (Contact Author)

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Tyler Shumway

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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