Firm Credit Risk Research Articles

Firm credit risk evaluation: a series two-stage DEA modeling framework

This paper documents a new series two-stage DEA modeling framework for credit risk evaluation in terms of operating performance efficiency and effectiveness that is implemented to a sample of listed Greek firms of basic resources and chemicals sector. In the series stages two types of DEA metrics are used: The first type is based on the range adjusted measure (RAM) whereas the second type is based on a common set of weights (CSW) of RAM. Performance inefficiency is uncovered in both performance dimensions, but the real problem of inefficiency of the sampled firms is a lower level of effectiveness, rather than operating performance efficiency. The operating efficiency is not correlated with effectiveness, and thus it seems that there is not a link between the performance at the operational (cost-oriented) and financial (profit-oriented) spaces of the firm. Therefore, sample firms should give more emphasis on their profit-oriented policies to ensure their success in the industry. The research framework may benefit not only Greek listed firms, but also firms in other countries to quantify their performance and improve their competitive advantages.

Credit Risk Determinants of Insurance Companies

This paper investigates the determinants of credit risk in insurance companies in the U.S. and Europe. Consistent with recent results for non-financial firms in the U.S., we find that equity volatility is a major determinant and predictor of CDS spreads for both U.S. and European insurers, even after controlling for the composition of their investment portfolios and other firm-specific characteristics such as leverage and macro controls. Furthermore, we find macroeconomic factors to affect the credit risk of European but not U.S. insurers, whereas cash holdings seem to be relevant in explaining the credit spreads of U.S. insurance companies. We find that cash holdings and credit spreads of U.S. insurers are positively correlated. However, the availability of cash reduces the credit risk of firms experiencing positive solvency shocks. Overall, our results are economically significant and suggest that equity and credit markets incorporate quickly relevant information on the creditworthiness of large insurers.

Blocks in Multiple Firms

We study the credit market implications of coowners hip: multiple firms sharing a common blockholder. We claim that the financial conditions of these firms signal the market about the controlling ability of the owner. In a 2001‐2008 sample of public US corporations, we show that coownership creates indirect financial link s between coowned firms. An increase in the credit ri sk of peer firms raises the firm’s credit risk. Mor eover, the relationship between peers becomes weaker (stronger) when the coowner loses (gains) control. Coownership also has implications for the firm’s borrowing cost s and its sensitivity to marketwide shocks.

Approximate Default Probabilities of a Holding Company, with Complete and Partial Information

This paper studies the valuation of credit risk for firms that own several subsidiaries or business lines. We provide simple analytical approximating expressions for probabilities of default, and for equity-debt market values, both in the case when the information is available in continuous time as well as in the case that it is not instantaneously available. The total firm's asset value being modeled as a sum of lognormal random variables, we use convex upper and lower approximations to infer these analytical approximating expressions. We extend the model to firms financed by multiple stochastic liabilities and conclude by numerical illustrations.

Monitoring credit risk in the social economy sector by means of a binary goal programming model

Monitoring the credit risk of firms in the social economy sector presents a considerable challenge, since it is difficult to calculate ratings with traditional methods such as logit or discriminant analysis, due to the relatively small number of firms in the sector and the low default rate among cooperatives. This paper introduces a goal programming model to overcome such constraints and to successfully manage credit risk using economic and financial information, as well as expert advice. After introducing the model, its application to a set of Spanish cooperative societies is described.

Accounting-Based Valuation, Taxation and Optimal Leverage

This theoretical study presents residual income valuation formulae that account for the firm's credit risk and investors' personal taxation. The formulae can determine optimal financial leverage and the value of accounting based debt covenants. The firm's default may be triggered by breach of covenants or be spontaneously chosen by equity holders, depending on accounting numbers. Credit risk makes valuations sensitive to investors' personal taxation.

Institutional Investors and Corporate Liquidity Management

We examine how institutional investors influence corporate liquidity choice between cash versus bank lines of credit using a comprehensive data set of real estate investment trusts. While cash offers managers unconditional control rights, credit lines subject managers to bank monitoring and restrictive covenants. We find that firms use more bank credit lines relative to cash under the oversight of institutional investors, especially independent institutional investors with a long-term investment horizon. These findings suggest that institutional investors engage in agency monitoring and attenuate the managers’ propensity to keep excessive cash relative to credit lines. Moreover, the sensitivity of bank liquidity utilization to institutional ownership is increasing in firm credit risk, which suggests that a motivation of institutional investors is to rely on banks to control corporate risk taking.

Firm entry, credit availability and monetary policy

This paper presents a dynamic general equilibrium model that incorporates firm entry under credit rationing. Goods-producing firms in this model are bank dependent in the sense that they have no choice but to borrow funds from banks to cover labor wages that must be paid in advance of production. The results show that a cut in the policy rate enhances firm entry by mitigating the severity of credit rationing. This policy transmission is different from the conventional balance sheet channel in that a change in the policy rate directly affects borrowers' credit availability. I also show that a sudden stop in the credit supply to new firms is most likely to occur shortly after a credit boom. This is because endogenous downward wage rigidity prohibits the credit risk of prospective firms from decreasing enough to re-equilibrate the loan market.

Model Implied Credit Spreads

I propose a new measure of credit risk, model implied credit spreads (MICS), which can be extracted from any structural credit risk model in which debt values are a function of asset risk and the payout ratio. I implement MICS assuming a barrier option framework nesting the Merton (1974) model of capital structure. MICS are the increase in the payout to creditors necessary to offset the impact of an increase in asset variance on the option value of debt. Endogenizing asset payouts, my measure (i) predicts higher credit risk for safe firms and lower credit risk for firms with high volatility and leverage than a standard distance to default (DD) measure and (ii) clearly outperforms the DD measure when used to predict corporate default or to explain variations in credit spreads.

Unfunded pension liabilities and sponsoring firm credit risk: an international analysis of corporate bond spreads

This paper tests empirically whether pension information derived by corporate pension accounting disclosures is priced in corporate bond spreads. The model represents a hybrid of more traditional accounting ratio-based models of credit risk and structural models of bond spreads initiated by Merton (1974). The model is fitted to 5 years of data from 2002 to 2006 featuring companies from the US and Europe. The paper finds that while unfunded pension liabilities are priced in the overall sample, they are not priced as aggressively as traditional leverage. Furthermore, an extended model shows that the pension–credit risk relation is most evident in the US and Germany, where unfunded pension liabilities are priced more aggressively than traditional forms of leverage. No pension–credit risk relation is found in the other countries sampled, notably the UK, Netherlands and France.

Financing and Risks of French Firms

This paper documents the role of capital markets in financing nonfinancial French firms since the adoption of the euro and analyzes its implications for risk using a structural model of credit risk. The analysis suggests that market financing has played a more important role in financing French firms than the euro area as a whole. The credit risk of French firms was reduced substantially between 2002 and the first half of 2007. The subsequent global turmoil has had a larger impact on smaller firms than larger ones.

Linking global economic dynamics to a South African-specific credit risk correlation model

In order to address practical questions in credit portfolio management it is necessary to link the cyclical or systematic components of firm credit risk with the firm's own idiosyncratic credit risk as well as the systematic credit risk component of every other exposure in the portfolio. This paper builds on the methodology proposed by Pesaran, Schuermann, and Weiner [Pesaran, M.H., Schuermann, T., and Weiner, S.M., (2004), Modeling regional interdependencies using a global error correcting macroeconometric model, Journal of Business and Economic Statistics, 22, 2, 129–169.] and supplemented by Pesaran, Schuermann, Treutler and Weiner [Pesaran, M.H., Schuermann, T., Treutler, B., and Weiner, S.M., (2006), Macroeconomic dynamics and credit risk: a global perspective, Journal of Money, Credit, and Banking, Volume 38, Number 5, August 2006, 1211–1261.] which has made a significant advance in credit risk modelling in that it avoids the use of proprietary balance sheet and distance-to-default data, focusing on credit ratings which are more freely available. In this paper a country-specific macroeconometric risk-driver engine which is compatible with and could feed into the GVAR model and framework of PSW (2004) is constructed, using vector error-correcting (VECM) techniques. This allows conditional loss estimation of a South African-specific credit portfolio but also opens the door for credit portfolio modelling on a global scale, as such a model can easily be linked to the GVAR model. The set of domestic factors is extended beyond those used in PSW (2004) in such a way that the risk-driver model is applicable for both retail and corporate credit risk. As such, the model can be applied to a total bank balance sheet, incorporating the correlation and diversification between both retail and corporate credit exposures. Assuming statistical over-identification restrictions, the results indicate that it is possible to construct a South African component for the GVAR model that can easily be integrated into the global component. From a practical application perspective the framework and model is particularly appealing since it can be used as a theoretically consistent correlation model within a South African-specific credit portfolio management tool.

Using Structural Models for Default Prediction

I propose a new procedure for extracting probabilities of default from structural credit risk models based on virtual credit spreads (VCS) and implement this approach assuming a simple Merton (1974) model of capital structure. VCS are derived from the increase in the payout to debtholders necessary to offset the impact of an increase in asset variance on the option value of debt and equity. In contrast to real-world credit spreads, VCS do not contain risk premia for default timing and recovery uncertainty, thus yielding a purer estimate of physical default probabilities. Relative to the Merton distance to default (DD) measure, my measure (i) predicts higher credit risk for safe firms and lower credit risk for firms with high volatility and leverage (ii) requires fewer parameter assumptions (iii) clearly outperforms the DD measure when used to predict corporate default.

A Structural Approach without Path Dependency

This paper proposes a structural model to price credit risk of firms with short-term and long-term debts. In Ikeda, Kobayashi, and Takahashi (2005), since it assumed that the short-term debt is refunded by issuing a new short-term debt only, the future face value of the short-term debt depends on the path of asset value, which makes analysis very complicated. In order to avoid the problem, we build a new model without path dependency by assuming the future face values of short term debts to be fixed. Furthermore, by the improvement of the model, we show that the model can apply to the pricing of credit derivatives, and present the example of the pricing of a convertible bond.

The Impact of Earnings on the Pricing of Credit Default Swaps

This study evaluates the impact of earnings on firm credit risk as captured by Credit Default Swaps (CDS). We find that earnings (changes) are negatively correlated with one-year swap premia (changes) after controlling for equity returns but not with longer term premia (changes). We also find that earnings surprises are significantly correlated with one-year CDS premia changes in the short window surrounding preliminary earnings dates and that absolute earnings surprises are significantly correlated with absolute one-year CDS premia changes in the short window surrounding SEC filing dates. These results suggest that high earnings convey favorable information about the short-term default risk of firms but not about the long term default risk. We further document that accruals/cash flow information conveyed by SEC filings provides information about long-term credit risk. Furthermore, the empirical results are consistent with structural and hybrid model-driven implications of CDS pricing.

: Merton (Bondholderss Optimal Strategic Behavior and Credit Spreads: Merton Model and Its Extension)

Korean Abstract: 본 논문은 기업의 청산비용이 존재하는 경우에 채권자의 최적의사결정이 기업의 신용위험에 미치는 영향에 대해 연구하였다. 기업의 파산이 기업 가치에 의해 외생적으로 주어지는 Merton 모형과는 달리 청산비용이 상당한 경우 기업 가치가 부도경계에 다다르더라도 청산을 연기하는 것이 채권자에게 최적의사결정임을 보여준다. 본 논문에서는 채권자의 전략적 행동에 따라 결정되는 부도프로세스로부터 위험채권의 가격을 계산하기 위해 미국형옵션 가격 계산과 유사한 방식의 유한차분법을 이용하였다. 부채비율과 변동성, 청산비용의 크기에 따라 신용스프레드가 어떻게 변화하는지 보여주고 있으며 기존의 모형과의 차이점에 대해 연구하였다. English Abstract: This paper investigates how the optimal decisions of bond holders affect the credit risk of firms when bankruptcy cost exists. Previous literature assumes that bankruptcy of a firm depends only on the firm’s value. We relax this assumption in our paper so that bondholders can delay the liquidation of the firm even though the firm value is lower than the exogenous default boundary. Our results show that delaying the liquidation can be the optimal behavior for bond holders when the bankruptcy cost is considerable. We implement the Crank-Nicolson finite difference method which is used in pricing American style options in order to value the risky bonds of which the default process is determined by the strategic behaviors of the bondholders. We investigate how credit spreads vary depending on the debt ratio, volatility and amount of the bankruptcy cost.

Structural Models of Corporate Bond Pricing: An Empirical Analysis

This article empirically tests five structural models of corporate bond pricing: those of Merton (1974), Geske (1977), Longstaff and Schwartz (1995), Leland and Toft (1996), and Collin-Dufresne and Goldstein (2001). We implement the models using a sample of 182 bond prices from firms with simple capital structures during the period 1986–1997. The conventional wisdom is that structural models do not generate spreads as high as those seen in the bond market, and true to expectations, we find that the predicted spreads in our implementation of the Merton model are too low. However, most of the other structural models predict spreads that are too high on average. Nevertheless, accuracy is a problem, as the newer models tend to severely overstate the credit risk of firms with high leverage or volatility and yet suffer from a spread underprediction problem with safer bonds. The Leland and Toft model is an exception in that it overpredicts spreads on most bonds, particularly those with high coupons. More accurate structural models must avoid features that increase the credit risk on the riskier bonds while scarcely affecting the spreads of the safest bonds. The seminal work of Black and Scholes (1973) and Merton (1974) in the area of corporate bond pricing has spawned an enormous theoretical literature on risky debt pricing. One motivating factor for this burgeoning literature is the perception that the Merton model cannot generate sufficiently high-yield spreads to match those observed in the market. Thus the recent theoretical literature includes a variety of extensions and

A Note on Credit Risk of Vertical Keiretsu Firms: Preliminary Evidence from the Japanese Automobile Industry

This paper empirically examines the relationship between the credit risk of Toyota, Nissan and Honda keiretsu-affiliated firms and the credit risk of the respective parent company. As credit spread data for keiretsu-affiliated firms were not available we create a keiretsu default index, as a proxy, using expected default probabilities obtained from the KMV and Leland and Toft (J. Finance 51, 987–1019, 1996) option pricing models. We find parent credit spreads do not Granger cause our keiretsu default index and vice versa in a bivariate vector autoregressive (VAR) framework.

An Approach to Fair Valuation of Insurance Liabilities Using the Firm’s Cost of Capital

There are two competing and seemingly different methodologies for calculating fair values—the direct and indirect methods. The direct approach has the advantage of providing a more reliable assessment of the risk of financial leverage. The indirect method can be structured to adjust for financial leverage, however, the methodology becomes excessively complex. The advantage of the indirect method is that it can be more easily related to exit prices. Intuitively, an exit price should reflect both the creditworthiness of the firm and the cost of capital of the firm. How are these two concepts related? This paper attempts to advance the fair valuation methodology by addressing these questions and presenting a methodology for deriving the firm or own credit risk assumption (to be used with the direct method) that is consistent with the cost of capital assumption used with the indirect method.

Corporate reliance on bank loans: an empirical analysis of UK property companies

The focus of this research paper is on the debt ownership choice of UK property companies. The data show that bank borrowings constitute more than half of the total outstanding debt of the quoted property sector, testifying to the widespread use of bank debt among property companies. We carried out four censored regressions to identify key factors influencing the firms’ decision to use bank loans instead of other types of debt. The results reveal that firm size and credit risk are significant determinants of the bank debt ratio of property companies. We also observe that institutional ownership has a strong positive effect on bank debt reliance. This finding suggests that institutional investors in property companies delegate the monitoring of the firm’s actions to the banks. We also find a weakly positive relationship between interest rate and bank debt ratio. The regression results further suggest that property market cycle, volatility of interest rates, and the firm’s leverage, growth opportunity, trading activities and age do not have any significant effect on the debt ownership choice.