When Do Firms Default? A Study of the Default Boundary

46 Pages Posted: 26 Mar 2008 Last revised: 6 Nov 2012

Date Written: November 2012

Abstract

In structural models of risky debt default is triggered when the market value of the firm's assets falls below a certain solvency boundary. Based on market values of defaulting firms, I estimate the default boundary to be 66% of the face value of debt, and find support for models in which the default timing is chosen endogenously to maximize the value of equity. But although default predictions based on the value of assets can match observed average default frequencies, they misclassify a substantial number of firms in cross-section, affecting the accuracy of boundary-based models. I show that using empirical specifications for the boundary can noticeably improve the models' ability to explain observed credit spreads.

Keywords: Credit risk, Default boundary, Insolvency, Cash shortage, Default

JEL Classification: G21, G30, G33

Suggested Citation

Davydenko, Sergei A., When Do Firms Default? A Study of the Default Boundary (November 2012). EFA Moscow Meetings Paper, AFA San Francisco Meetings Paper, WFA Keystone Meetings Paper, Available at SSRN: https://ssrn.com/abstract=672343 or http://dx.doi.org/10.2139/ssrn.672343

Sergei A. Davydenko (Contact Author)

University of Toronto - Finance Area ( email )

Toronto, Ontario M5S 3E6
Canada

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