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
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: Suggested Citation