Predicting the default risk of firms: a model with safety covenants

Authors: Yu-Ling Lin; Ta-Cheng Chang;

Journal: Chia Da Management Review. Jun. 2009, 29(1): 103-138.

Keywords: Credit risk model; Black-Scholes-Merton BSM model; Barrier option model; Tobit regression

Abstract:
This study uses barrier option theory to establish a credit risk model with greater relevance to the process of default by firms in the real world. As compared to the traditional Black-Scholes-Merton (BSM) structural model, which makes use of market information along with the results of the empirical testing of default predicting performance, we suggest that our down-and-out call option (DOC) model, established on the basis of barrier option theory, provides superior performance. When factoring in profitability, and when using the censored Tobit regression model to observe the characteristics of these two structural models, we find that the DOC model is more effective at predicting default events; we therefore conclude that the DOC model is another appropriate model for the measurement of the credit risk of firms.