Abstract
AbstractThe purpose of this paper is to develop and test a model of the probability of default on corporate bonds that is based upon the tenets of the contingent claims literature. Equity is considered a call option on the firm's assets, with the exercise price being the face value of the firm's debt. Using this framework, a model is developed with the probability of default as a function of five variables‐firm value, face value of the debt, time to maturity of the debt, instantaneous return and standard deviation of firm value. The model is found to be statistically significant, explains approximately 54 percent of the variation in the bond ratings, and correctly classifies, 68 percent and 66 percent of the bonds in an initial and holdout sample, respectively, according to their agency ratings. The model is also found to provide a reasonable estimate of the probability of default.
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