Are Ratings the Worst Form of Credit Assessment Apart from All the Others?
62 Pages Posted: 28 Feb 2012 Last revised: 27 Jun 2016
Date Written: February 22, 2012
We present a prediction model to forecast corporate defaults. In a theoretical model, under incomplete information in a market with publicly traded equity, we show that our approach must outperform ratings, Altman’s Z-score, and Merton’s distance to default. We reconcile the statistical and structural approaches under a common framework, i.e., our approach nests Altman’s and Merton’s approaches as special cases. Empirically, we cannot reject the superiority of our approach.Furthermore, the numbers of observed defaults align well with the estimated probabilities. Finally, with rank transforms, we obtain cycle-adjusted forecasts that still outperform ratings.
Keywords: credit rating agencies, distance to default, z-score, zeta-score, default prediction
JEL Classification: G01, G18, G24
Suggested Citation: Suggested Citation