The Role of Asset Payouts in the Estimation of Default Barriers
38 Pages Posted: 1 Feb 2021
Date Written: January 2021
In the barrier option model of corporate security valuation, the firm's creditors impose a default-triggering barrier on the firm value to protect their claim. One of the disputed issues in the literature is whether the implied default barrier is positive, and whether it is above or below the firm's leverage. We extend the model of Brockman and Turtle by embedding asset payouts in the valuation of shareholder's equity. Using a sample of US stocks from the NYSE, AMEX, and NASDAQ, our paper exploits market and firm information to arrive at more accurate estimates of the parameters. The implied default barrier is computed for thirty 2-digit SIC groups, including industrials and banks. Our results show that the implied default barrier is lower than it is in the received literature, and it can be less than leverage, even zero for some firms. The implied physical probabilities of default are significantly lower in the presence of payouts, providing a closer fit to the historical corporate default rates, particularly for issuers of speculative-grade bonds.
Keywords: Contingent Claims, Barrier Option, Issuer Credit Ratings, Default Barrier
JEL Classification: G12, G33, G28
Suggested Citation: Suggested Citation