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A comparative study of the probability of default for global financial firms

António Câmara, Ivilina Popova and Betty Simkins

Journal of Banking & Finance, 2012, vol. 36, issue 3, 717-732

Abstract: This article presents a modification of Merton’s (1976) ruin option pricing model to estimate the implied probability of default from stock and option market prices. To test the model, we analyze all global financial firms with traded options in the US and focus on the subprime mortgage crisis period. We compare the performance of the implied probability of default from our model to the expected default frequencies based on the Moody’s KMV model and agency credit ratings by constructing cumulative accuracy profiles (CAP) and the receiver operating characteristic (ROC). We find that the probability of default estimates from our model are equal or superior to other credit risk measures studied based on CAP and ROC. In particular, during the subprime crisis our model surpassed credit ratings and matched or exceeded KMV in anticipating the magnitude of the crisis. We have also found some initial evidence that adding off-balance-sheet derivatives exposure improves the performance of the KMV model.

Keywords: Default probabilities; Financial crises; Option pricing; KMV model (search for similar items in EconPapers)
JEL-codes: G01 G13 G33 (search for similar items in EconPapers)
Date: 2012
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Handle: RePEc:eee:jbfina:v:36:y:2012:i:3:p:717-732