AJM - Abstracts

Volume 31 Number 2 December 2006

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

Philip Gharghori

Howard Chan

Robert Faff

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

Download this article.

Keywords

DEFAULT-RISK MODELS; DEFAULT PREDICTION

Contact Details

Philip Gharghori
Department of Accounting and Finance, PO Box 11E, Monash University, VIC 3800

Howard Chan
Department of Finance, University of Melbourne, VIC 3010

Robert Faff
Department of Accounting and Finance, PO Box 11E, Monash University, VIC 3800
E-mail: robert.faff@buseco.monash.edu.au