A Market-Based Framework for Bankruptcy Prediction

50 Pages Posted: 16 Apr 2004

See all articles by Alexander Reisz

Alexander Reisz

Office of the Comptroller of the Currency

Claudia Perlich

IBM Corporation - Thomas J. Watson Research Center

Date Written: May 25, 2004

Abstract

We estimate probabilities of bankruptcy for 5,784 industrial firms in the period 1988-2002 in a model where common equity is viewed as a down-and-out barrier option on the firm's assets. Asset values and volatilities as well as firm-specific bankruptcy barriers are simultaneously backed out from the prices of traded equity. Implied barriers are significantly positive and monotonic in the firm's leverage and asset volatility. Our default probabilities outperform the ones inferred from a standard Black-Scholes/Merton and KMV frameworks, both in terms of discriminatory power and calibration. In particular, the possibility of early bankruptcy resolves some of the well-documented miscalibration. We also find that accounting-based measures such as Altman Z- and Z"-scores outperform structural models in one-year-ahead bankruptcy predictions, to fade away as the forecast horizon is extended.

Keywords: Barrier option, default probability

JEL Classification: G13, G33

Suggested Citation

Reisz, Alexander and Perlich, Claudia, A Market-Based Framework for Bankruptcy Prediction (May 25, 2004). Available at SSRN: https://ssrn.com/abstract=531342 or http://dx.doi.org/10.2139/ssrn.531342

Alexander Reisz (Contact Author)

Office of the Comptroller of the Currency ( email )

400 7th Street SW
Washington, DC 20219
United States
(202) 874 6167 (Phone)
(202) 874 5394 (Fax)

Claudia Perlich

IBM Corporation - Thomas J. Watson Research Center ( email )

Route 134
Kitchawan Road
Yorktown Heights, NY 10598
United States

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