Estimating Multi-Period Corporate Credit Risk - A Cash Flow Based Approach

Abstract

Of all the structural form credit models, this is one of the first studies to suggest using a firm's future cash flows to estimate its asset value distribution, rather than employing a firm's equity market value. We employ a state-dependent free cash flow process to generate a firm's multi-period unconditional asset value distributions and therefore to obtain the firm's multi-period unconditional probability of default and expected recovery rate endogenously without the controversies of the Merton-type models. The results of an empirical comparison with four famous structural form models in estimating corporate credit risk show that the proposed model outperforms the others in both good and poor credit quality samples.

Keywords: Multi-period Credit Risk, Structural Form Model, Cash flow

JEL Classification: G30