An Empirical Test of Option Based Default Probabilities Using Payment Behaviour and Auditor notes

by Tom E. S. Farmen of the Norwegian University of Science and Technology,
Sjur Westgaard of the Norwegian University of Science and Technology, and
Nico van der Wijst of the Norwegian University of Science and Technology

July 8, 2004

Abstract: This paper empirically tests the Black and Scholes, Merton framework for bankruptcy, based on a priori hypotheses from the comparative statics of the model, using payment behavior and auditor notes as a proxy for financial distress. The results indicate that the standard deviation of equity is the most significant parameter in the model, but also equity ratio seems to have a significant influence on the probability of default. The results show that an increase in the volatility of equity increases the probability of default, while an increase in the equity ratio or drift of equity reduces the probability of bankruptcy. The coefficient of the time horizon of debt is close to zero, aligned with the ambiguous effect of the time horizon of debts influence on the probability of bankruptcy. This is in line with the a priori hypothesis derived from the comparative statics from the model.

JEL Classification: G12, G33.

Keywords: Option theory, Bankruptcy prediction, Empirical tests.

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