Appendix 2: Measuring Default Probability A Practical Approach

Overview

Three basic types of information are relevant to the default probability of a firm: financial statements, market prices of the firm s debt and equity, and subjective appraisals of the firm s prospects and risk. Financial statements are inherently backward looking; they are reports of the past. Prices, in contrast, are inherently forward looking. Investors form debt and equity prices as they anticipate the firm s future. In determining the market prices, investors use, among many other things, subjective appraisals of the firm s prospects and risk, financial statements, and other market prices. This information is combined using their own analysis and synthesis and results in their willingness to buy and sell the firm s debt and equity securities. Market prices are the result of the combined willingness of many investors to buy and sell, and thus prices embody the synthesized views and forecasts of many investors.

The most effective default measurement, therefore, derives from models that utilize both market prices and financial statements. We do not mean here that markets are perfectly efficient in this synthesis. We assert only that it is difficult to do a better job than the markets. That is, it is very difficult to consistently beat the market. Consequently, where available, we want to utilize market prices to determine default risk because prices add considerably to the predictive power of the estimates.

Vasicek and Kealhofer have extended the Black-Scholes-Merton framework to produce a model of default probability known as the Vasicek-Kealhofer (VK) model. This model assumes that the firm s...