Academic journal article Journal of Business Economics and Management

Examining What Best Explains Corporate Credit Risk: Accounting-Based versus Market-Based Models

Academic journal article Journal of Business Economics and Management

Examining What Best Explains Corporate Credit Risk: Accounting-Based versus Market-Based Models

Article excerpt

Reference to this paper should be made as follows: Trujillo-Ponce, A.; Samaniego-Medina, R.; Cardone-Riportella, C. 2014. Examining what best explains corporate credit risk: accounting-based versus market-based models, Journal of Business Economics and Management 15(2): 253-276.

JEL Classification: C52, G13, G33, M41.


The ability of investors or potential lenders to correctly measure the credit risks of companies is an issue that has historically attracted attention in the financial literature. This desire to understand the determinants of default risk has grown in strength following the bankruptcy of Lehman Brothers in September 2008 and the 2011 sovereign debt crisis in Europe.

The use of credit risk models has been fully established in the literature since 1966, when Beaver published his pioneering work, 'Financial ratios as predictors of failure' in Journal of Accounting Research, which served as a reference for subsequent investigations (1). This univariate model was followed by a multidimensional-type model that integrates all of the relevant variables that contribute to the success or failure of a company and provides a single diagnosis or overall assessment of their creditworthiness. The two best-known multidimensional models of credit risk are Altman's Z-score model (1968) and Ohlson's O-score model (1980). These models both use information drawn from the financial statements of borrowers and are consequently known as accounting-based models.

More recently, credit risk models have used data from the capital markets in which the shares or bonds issued by the companies in question are traded. Among the models that use market data, we must highlight those based on Merton (1974), who introduced the original model that led to subsequent research on 'structural models' (2). Relying on the contingent claims analysis of Black and Scholes (1973), Merton (1974) proposes considering the value of the equity as a call option on the value of the assets of the firm with a strike price equal to the face value of the firm's debt. From this perspective, the company will default if its asset value falls below a certain default boundary related to the company's outstanding debt. However, Merton's (1974) model presents certain unrealistic assumptions; in particular, it represents the liability structure of the firm as consisting only of a non-callable zero coupon bond and assumes that bankruptcy cannot be triggered before maturity. In addition, this model presumes that the absolute priority rule always holds at maturity, implying that equity holders can only obtain a positive payoff after debt holders are completely reimbursed.

Many papers have extended Merton's (1974) original model to incorporate more realistic assumptions. Black and Cox (1976) allow default to occur as soon as a firm's asset value falls below a certain threshold (i.e., at any time). Geske (1977) uses the compound option technique to value a corporation's risky coupon bonds. Anderson and Sundaresan (1996), Mella-Barral and Perraudin (1997) propose a structural model that accounts for the possibility of debt renegotiation. A number of other papers have also made more sophisticated assumptions, including Leland (1994), Longstaff and Schwartz (1995), Leland and Toft (1996), Fan and Sundaresan (2000), Collin-Dufresne and Golstein (2001). However, despite the theoretical advances of second-generation structural-form models with respect to the original Merton framework, Wei and Guo (1997) find no evidence that the Longstaff and Schwartz (1995) model produces a better empirical performance than the Merton (1974) model in the Eurodollar market.

Our paper is closely related to recent studies that have investigated whether accounting-based or market-based approaches are more appropriate for measuring corporate credit risk. Accounting models have been criticized for the historic nature of the information that they use as inputs and for not accounting for the volatility of a firm's assets during estimations of its risk of default (e. …

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