On the Determinants of the Implied Default Barrier

by Georges Dionne HEC Montréal, and
Sadok Laajimi of HEC Montréal

April 8, 2009

Abstract: We use the maximum likelihood (ML) estimation approach to estimate the default barriers from market values of equities for a sample of 762 public industrial Canadian firms. The ML approach allows us to estimate the asset instantaneous drift, volatility and barrier level simultaneously, when the firm's equity is priced as a Down-and-Out European call (DOC) option. We find that the estimated barrier is positive and significant in our sample. Moreover, we compare the default prediction accuracy of the DOC framework with the KMV-Merton approach. Using probit estimation, we find that the default probability from the two structural models provides similar in-sample fits, but the barrier option framework achieves better out-of-sample forecasts. Regression analysis shows that leverage is not the only determinant of the default barrier. The implied default threshold is also positively related to financing costs, and negatively to liquidity, asset volatility and firm size. We also find that liquidation costs, renegotiation frictions and equity holders' bargaining power increase the implied default barrier level.

JEL Classification: G32, G33.

Keywords: Barrier option; Default barrier; Bankruptcy prediction; Maximum likelihood estimation; Strategic default

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