Quantifying Credit Risk II: Debt Valuation

“Quantifying Credit Risk I” (in the January/February 2003 Financial Analysts Journal) presented evidence on the effectiveness of using the information in market equity prices to predict corporate default. This Part II links those results to the valuation of corporate debt and shows that, contrary to previous negative results, the approach pioneered by Fischer Black, Myron Scholes, and Robert Merton provides superior explanations of secondary-market debt prices. Prior research using the Merton approach to value corporate liabilities has yielded negative results. This article reports on new research indicating that the Merton approach, in fact, yields quite accurate estimates of the secondary-market prices of corporate bonds. The primary difference between this research and earlier work is the substitution of empirically based default probabilities for the lognormality assumption of the conventional Merton method. This article is the second in a two-part series on quantifying credit risk. Part I, which was published in the January/February 2003 issue of the Financial Analysts Journal, presented results of research on the model's default-predictive power. The ultimate aim of default prediction is to determine the appropriate market value of default risk. Part II explores the connection between default prediction and valuation. First, it shows that the levels of predicted individual and aggregate probabilities of default from the KMV model display considerable variation through time and that these predictions correspond to the actual, subsequently realized levels of default. Second, contrary to past understanding, most of the variation in the spreads on corporate bonds can be attributed to variation in expected default probability, not to the risk premium on corporate bonds, which is relatively stable through time. Third, Part II shows that the term structure of bond spreads corresponds empirically to the term structure of default risk. Finally, the default probabilities from the KMV model are used in an option theoretic framework to explain individual corporate debt spreads. In sharp contrast to previous academic work, the tests I explore found that the generalized Merton approach provides significantly better explanations of debt prices than those provided by alternative models. These tests used significantly more data and more powerful alternative models than previous studies. The findings suggest that the Black–Scholes–Merton approach, when appropriately executed, provides the long-sought quantification of credit risk. As an objective cause-and-effect model, the KMV model also provides analytical insights into corporate behavior, thus creating the basis for a continuing rich research program into default risk, capital structure, and debt valuation. For portfolio managers, the link from debt values to equity values featured in the KMV model provides a way to understand the correlations between individual credit risks and the correlation between the performance of equity and corporate debt portfolios. For managers of debt portfolios, the results suggest significant new approaches to decomposing and evaluating portfolio performance.