How to Gauge the Default Risk? An empirical application of structural-form models

by Su-Lien Lu of National United University, Taiwan, and
Pei-Chen Tsai of National United University, Taiwan

July 2009

Abstract: To estimate expected default probabilities of firms, this article tests three structural form models: Leland and Toft (1996), Ericsson and Reneby (1998) and Fan and Sundaresan (2000). We implement these models using a sample of 628 Taiwanese firms with capital structures during the period 1995-2006 to predict default risk of failed companies. Empirical results show that the predictabilities of all three models exceed 50 percent. The accuracy of predictions for Leland and Toft (1996), Ericsson and Reneby (1998) and Fan and Sundaresan (2000) are 66.07%, 82.14% and 75%, respectively. Therefore, we conclude that the model of Ericsson and Reneby (1998) performs best in predicting the default risk of a firm.

JEL Classification: G10, G21.

Keywords: Structural-form model, expected default probability.

Published in: International Research Journal of Finance and Economics, Issue 29, (July 2009), pp. 227-237.

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