An Empirical Analysis of Default Prediction Models: Evidence from lndian Listed Companies

Abstract

This paper attempts to evaluate the predictive ability of three default prediction models: the market-based KMV model, the Z-score model using discriminant analysis (DA), and the logit model; and identifies the key default drivers. The research extends prior empirical work by modeling and testing the impact of financial ratios, macro-economic factors, corporate governance and firm-specific variables in predicting default. For the market-based model, the author has extended the works of KMV in developing a suitable algorithm for determining probability of default (PD). While for the KMV model, the continuous observations of PD are used as the dependent variable, for the accounting-based models, ratings assigned are the proxy for default (those rated ’D’ are defaulted and rated ‘AAA’ and ‘A’ are solvent). The research findings largely support the hypothesis that solvency, profitability and liquidity ratios do impact the default risk, but adding other covariates improves the predictive ability of the models. Through this study, the author recommends that accounting –based models and market based models are conceptually different. While market-based models are forward looking and inclusion of market data makes the default risk quantifiable; to make the PD more exhaustive, it is important to factor in the information provided in the financial statements. The conclusions drawn are that the disclosures in financial statements can help predict default risk as financial distress risk is likely to evolve over time and will be reflected in financial statements beyond accounting ratios. Moreover this will also help divulge “creative accounting” practices by corporates.