Forecasting default with the Merton distance to default model

Sreedhar T. Bharath, Tyler Shumway

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Abstract

We examine the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model. We compare the model to a quot;naïve" alternative, which uses the functional form suggested by the Merton model but does not solve the model for an implied probability of default. We find that the naïve predictor performs slightly better in hazard models and in out-of-sample forecasts than both the Merton DD model and a reduced-form model that uses the same inputs. Several other forecasting variables are also important predictors, and fitted values from an expanded hazard model outperform Merton DD default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with Merton DD probabilities after adjusting for agency ratings and bond characteristics. We conclude that while the Merton DD model does not produce a sufficient statistic for the probability of default, its functional form is useful for forecasting defaults.

Original languageEnglish (US)
Pages (from-to)1339-1369
Number of pages31
JournalReview of Financial Studies
Volume21
Issue number3
DOIs
StatePublished - May 1 2008

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ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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