A Simple Empirical Model of Equity-Implied Probabilities of Default
by Edward Altman of the New York 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.
Keywords: Default Risk, Equity, Fundamental Information