Alternative Bankruptcy Prediction Models using Option-Pricing Theory

Abstract

We examine the empirical properties of the theoretical Black–Scholes–Merton (BSM) bankruptcy model. We evaluate the predictive ability of various existing modifications of the BSM model and extend prior studies by estimating volatility directly from market-observable returns on firm value.We show that parsimonious models using our direct market-observable volatility estimate perform better than alternative, more sophisticated, models. Our findings suggest the adoption of simpler modelling approaches relying on market data when implementing the BSM model.

Keywords: Bankruptcy prediction, Option-pricing theory, Volatility estimation

JEL Classification: G33, G3, G0, M4