Distance to Insolvency

AIRA Journal, Vol.32: No.4, 2020

5 Pages Posted: 27 Nov 2019 Last revised: 18 Feb 2020

See all articles by J.B. Heaton

J.B. Heaton

One Hat Research LLC; J.B. Heaton, P.C.

Date Written: February 2020

Abstract

Insolvency often precedes default for nonpayment of debt. A firm is instantaneously insolvent whenever the market value of its assets is below the face value of its debt. Default occurs when the firm is instantaneously insolvent when the firm's debt matures. The natural log of the ratio of the market value of assets to face value of debt measures distance to insolvency (or degree of insolvency) in the Black-Scholes formula and Merton distance to default. The measure is useful outside of the restrictive conditions of option pricing theory. It is negative for instantaneously insolvent firms, zero for firms at the border of solvency and insolvency, and positive for an instantaneously solvent firm.

Keywords: distance to default, insolvency, Black-Scholes, Merton

Suggested Citation

Heaton, J.B., Distance to Insolvency (February 2020). AIRA Journal, Vol.32: No.4, 2020. Available at SSRN: https://ssrn.com/abstract=3485325 or http://dx.doi.org/10.2139/ssrn.3485325

J.B. Heaton (Contact Author)

One Hat Research LLC ( email )

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United States

J.B. Heaton, P.C. ( email )

Chicago, IL
United States
(312) 487-2600 (Phone)

HOME PAGE: http://jbheaton.com

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