Estimation of the default risk of publicly traded Canadian companies

Georges Dionne (), Sadok Laajimi (), Sofiane Mejri () and Madalina Petrescu ()
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Sadok Laajimi: HEC Montreal, Canada Research Chair in Risk Management
Sofiane Mejri: HEC Montreal, Canada Research Chair in Risk Management
Madalina Petrescu: HEC Montreal, Canada Research Chair in Risk Management

No 06-5, Working Papers from HEC Montreal, Canada Research Chair in Risk Management

Abstract: Two models of default risk are prominent in the financial literature: Merton’s structural model and Altman’s reduced-form model. The former has the benefit of being responsive, since the probabilities of default can continually be updated with the evolution of firms’ asset values. Its main flaw lies in the fact that it may over- or underestimate the probabilities of default, since asset values are unobservable and must be extrapolated from the share prices. The latter, on the other hand, is more precise, since it uses firms’ accounting data—but it is less flexible. In this paper, we investigate the hybrid contingent claim approach with publicly traded Canadian companies listed on the Toronto Stock Exchange. Our goal is to assess how combining their continuous valuation by the market (structural model) with the value given in their financial statements (reduced- form model) improves our ability to predict their probability of default. Our results indicate that the predicted structural probabilities of default (PDs from the structural model) contribute significantly to explaining default probabilities when PDs are included alongside the retained accounting variables. We also show that quarterly updates to the PDs add a large amount of dynamic information to explain the probabilities of default over the course of a year. This flexibility would not be possible with a reduced-form model. We also conducted a preliminary analysis of correlations between structural probabilities of default for the firms in our database. Our results indicate that there are substantial correlations in the studied data.

Keywords: Default risk; public firm; structural model; reduced form model; hybrid model; probit model; Toronto Stock Exchange; correlations between default probabilities (search for similar items in EconPapers)
JEL-codes: G21 G24 G28 G33 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2006-03-21
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Related works:
Working Paper: Estimation of the Default Risk of Publicly Traded Canadian Companies (2006)
Working Paper: Estimation of the Default Risk of Publicly Traded Canadian Companies (2006)
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