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A Multi-period Corporate Credit Model---An Intrinsic Valuation Approach

by Tsung-kang Chen of the National Taiwan University, and
Hsien-hsing Liao of the National Taiwan University

June 26, 2005

Abstract: Credit risk models develops rapidly recently but mainly on the reduced-form and systematic factor models. Structural-form models grow relatively slower due to the dilemmas arising from using a market value based valuation method. Within the framework of structural form model, this study adopts an alternative firm valuation approach---an intrinsic valuation approach that can avoid the predicaments faced by traditional structure models. This study employ intrinsic value calculated from free cash flows rather than use equity market value to estimate firm (asset) value distribution. Based upon two significant cash flow characteristics- "mean-reversion" and "allowing positive or negative values" and the concept of varying coefficient model, this study develops a multi-period structural form credit risk model by constructing a "Time-dependent stochastic cash flow model". It considers the impacts of industrial economic state changes on the structure of a firm's cash flows model (i.e. the parameters of the cash flow model) through incorporating information generated from a stochastic model of industrial economic state. To perform a multi-period firm valuation, this cash flow model needs only publicly available information of corporate finance and the industrial economic state (i.e. the industrial cyclicality information). With the information of a firm's future value distribution and debt, a firm's future credit risk (default probabilities and expected recovery rates) can be estimated.

JEL Classification: G3.

Keywords: Time-dependent stochastic cash flow, Intrinsic credit model.

Previously titled: A Cash Flow Based Multi-period Credit Risk Model

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