A Market-Based Framework for Bankruptcy Prediction
50 Pages Posted: 16 Apr 2004
Date Written: May 25, 2004
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: Suggested Citation