A Simple Empirical Model of Equity-Implied Probabilities of Default

by Edward Altman of the New York University,
Neil Fargher of the New York University, and
Egon Kalotay of the Australian National University

October 24, 2010

Abstract: We approximate the likelihood of default inferred from equity prices using accounting-based measures, firm characteristics and industry-level expectations. Such empirical approximations enable the timely modeling of distress risk in the absence of equity prices or sufficient historical records of defaults. We show, through a series of re-sampling experiments, that our models deliver out-of-sample classification performance comparable to that of default likelihood inferred from equity prices using the Black-Scholes-Merton framework. Further, we document the distinct roles of firm-level and macroeconomic information in capturing time-varying exposure to the risk of financial distress. More generally, our results underscore the importance of treating equity-implied default probabilities and fundamental variables as complementary rather than competing sources of predictive information.

JEL Classification: G10, G12, G14, G21.

Keywords: Default Risk, Equity, Fundamental Information

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