Investigating the Performance of Alternative Default-Risk Models: Option-Based Versus Accounting-Based Approaches

Philip Gharghori, Howard Chan, Robert Faff

Research output: Contribution to journalArticleResearchpeer-review

29 Citations (Scopus)

Abstract

In this paper we evaluate the performance of three alternate default-risk models, seeking to find that measure which performs best, using a comprehensive sample drawn from the Australian equities market. The first two models are option-based models and are derived from Merton's (1974) insight that equity can be viewed as a call option on a firm's assets. In the first model, equity is modelled as a standard call option. In the second model, equity is modelled as a path-dependent barrier option. The third model is created using accounting ratios and is similar to Altman's (1968) Z-Score. To assess which of the models is superior, we consider variations of each model and then rely on prediction-oriented tests that focus on whether a firm subsequently defaults. Our results show that the option-based models clearly outperform their accounting ratio counterparts. Furthermore, our analysis suggests that the option-based models are very successful at ranking firms by default probability. It is noteworthy that the performances of the option-based models are difficult to distinguish from each other.

Original languageEnglish
Pages (from-to)207-234
Number of pages28
JournalAustralian Journal of Management
Volume31
Issue number2
DOIs
Publication statusPublished - Dec 2006
Externally publishedYes

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