Alfredo Ibáñez Rodríguez

 

“A robust measure of default-risk based on endogenous credit-risk models” 

 

Abstract: 

This paper shows that the corporate default event defined by Leland-type endogenous credit-risk models (i.e., a sufficiently low asset value) can be rewritten in terms of a low ratio of the equity price to the firm's negative net cash-flow (i.e., debt service and/or negative earnings). As a result, credit risk, the probability of default, is the probability of this ratio becoming small. By contrast to the asset value and its endogenous default boundary, which are unobservable and hence require a model (such as Merton (1974)) to be recovered, equity prices and net cash-flows (if only with lags in practice) are readily available. We use this new insight to reconcile and provide a rationale (based on endogenous default) for many empirical findings of the extensive literature that predicts corporate default by using reduced-form models. 

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