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Mapping Corporate Drift towards Default: A study of distance to default of Indian corporates

by Arindam Bandyopadhyay of the National Institute of Bank Management (NIBM), India

November 4, 2005

Abstract: Mapping corporate drift towards default is becoming a crucial part of any financial institution's credit risk measurement. Even the banks with an internal rating system need to check the discriminatory power of the internal rating. This article focus on the use of option based models in credit risk management. Using the Black and Scholes and Merton model (BSM), we present a framework to optimally use stock market and balance sheet information of the company to predict its distance to default over a horizon of one year. We then apply this methodology on 53 large Indian Corporates over the year 1998 to 2004 and find that option model can accurately predict the default status of the firm even before the ratings are published by CRISIL. Next, in a logistic regression, we investigate the ability of the market value of assets and liquidity measures to predict default. Our empirical analysis shows that distance to default is the single most important predictor variable which can act as a single control for asset value, asset volatility and balance sheet liquidity and hence can outperform any other ratio based models.

JEL Classification: G21, G33.

Keywords: Distance to Default, Option theory, Bankruptcy.

Published in: Two parts...
1) Journal of Risk Finance, Vol. 8, No. 1, (January 2007), pp. 35-45.
2) Journal of Risk Finance, Vol. 8, No. 1, (January 2007), pp. 46-55.

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