Using option theory and fundamentals to assess the default risk of listed firms

ISSN： 1740-8008

Source： International Journal of Accounting, Auditing and Performance Evaluation, Vol.4, Iss.3, 2007-12, pp. : 305-331

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Abstract

In this paper, we use option based measures of financial performance that utilise market information in a binary probit regression to examine their informational context and properties as distress indicators and to estimate default probabilities for listed firms. We then enrich them with fundamentals that utilise accounting information. The results suggest that, by adding accounting information from financial statements to market information from equity prices, we can improve both in sample fitting and out of sample predictability of defaults. Therefore, option theory does not generate sufficient statistics of the actual default frequency. Our main conclusion is that, while market information can be extremely valuable, it is most useful when coupled with accounting information in assessing the default risk of listed firms.