Keywords
distance to default, default prediction, credit risk modeling
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 "nai:ve" 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 nai:ve 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 Publication Citation
Forecasting Default with the Merton Distance to Default Model, 2008, with Sreedhar Bharath, Review of Financial Studies
BYU ScholarsArchive Citation
Bharath, Sreedhar T. and Shumway, Tyler, "Forecasting Default with the Merton Distance to Default Model" (2008). Faculty Publications. 9285.
https://scholarsarchive.byu.edu/facpub/9285
Document Type
Peer-Reviewed Article
Publication Date
2008
Publisher
Review of Financial Studies
Language
English
College
Marriott School of Business
Department
Finance
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