Performance of default risk model with barrier option framework and maximum likelihood estimation: Evidence from Taiwan

Heng-Chih Chou and David Wang

Physica A: Statistical Mechanics and its Applications, 2007, vol. 385, issue 1, 270-280

Abstract: We investigate the performance of a default risk model based on the barrier option framework with maximum likelihood estimation. We provide empirical validation of the model by showing that implied default barriers are statistically significant for a sample of construction firms in Taiwan over the period 1994–2004. We find that our model dominates the commonly adopted models, Merton model, Z-score model and ZETA model. Moreover, we test the n-year-ahead prediction performance of the model and find evidence that the prediction accuracy of the model improves as the forecast horizon decreases. Finally, we assess the effect of estimated default risk on equity returns and find that default risk is able to explain equity returns and that default risk is a variable worth considering in asset-pricing tests, above and beyond size and book-to-market.

Keywords: Default risk model; Barrier option framework; Default prediction; Maximum likelihood estimation (search for similar items in EconPapers)
Date: 2007
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:385:y:2007:i:1:p:270-280

DOI: 10.1016/j.physa.2007.06.044

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