Default Prediction Models: The Role of Forward-Looking Measures of Returns and Volatility

39 Pages Posted: 30 May 2017 Last revised: 11 Feb 2018

See all articles by Hong Miao

Hong Miao

Colorado State University, Fort Collins - Department of Finance & Real Estate

Sanjay Ramchander

Colorado State University, Fort Collins - Department of Finance & Real Estate

Patricia A Ryan

Colorado State University, Fort Collins - Department of Finance & Real Estate

Tianyang Wang

Colorado State University - Department of Finance & Real Estate

Date Written: July 27, 2017

Abstract

This paper proposes a variant application of the Merton distance-to-default model by employing implied volatility and implied a cost of capital to forecast defaults. The proposed model's results are compared with predictions obtained from three popular models in different setups. We find that our "best" model, which contains both forward-looking proxies does outperform other models with a default prediction accuracy rate of 89%. Additional analysis using a discrete-time hazard model indicates that the psuedo-R2 values from regression models that include the two implied measures are as high as 51%. Overall, our results establish the informational relevance of implied cost of capital and implied volatility in predicting defaults.

Keywords: Default Prediction, Distance to Default, Implied Cost of Capital, Implied Volatility

JEL Classification: G130

Suggested Citation

Miao, Hong and Ramchander, Sanjay and Ryan, Patricia A and Wang, Tianyang, Default Prediction Models: The Role of Forward-Looking Measures of Returns and Volatility (July 27, 2017). Journal of Empirical Finance, Vol. 46, 2018. Available at SSRN: https://ssrn.com/abstract=2975804 or http://dx.doi.org/10.2139/ssrn.2975804

Hong Miao (Contact Author)

Colorado State University, Fort Collins - Department of Finance & Real Estate ( email )

Fort Collins, CO 80523
United States

Sanjay Ramchander

Colorado State University, Fort Collins - Department of Finance & Real Estate ( email )

Fort Collins, CO 80523
United States
970-491-6681 (Phone)

Patricia A Ryan

Colorado State University, Fort Collins - Department of Finance & Real Estate ( email )

Fort Collins, CO 80523
United States

Tianyang Wang

Colorado State University - Department of Finance & Real Estate ( email )

Finance and Real Estate Department
1272 Campus Delivery
Fort Collins, CO 80523
United States

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