Accounting-based versus market-based cross-sectional models of CDS spreads

Models of financial distress rely primarily on accounting-based information (e.g. [Altman, E., 1968. Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. Journal of Finance 23, 589-609; Ohlson, J., 1980. Financial ratios and the probabilistic prediction of bankruptcy....

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Journal Title: Journal of banking & finance Vol. 33; no. 4; pp. 719 - 730
Authors: Paul Hanouna, Atulya Sarin, Sanjiv R. Das
Format: Article
Published: Apr 2009
Subjects:
Summary: Models of financial distress rely primarily on accounting-based information (e.g. [Altman, E., 1968. Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. Journal of Finance 23, 589-609; Ohlson, J., 1980. Financial ratios and the probabilistic prediction of bankruptcy. Journal of Accounting Research 19, 109-131]) or market-based information (e.g. [Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. Journal of Finance 29, 449-470]). In this paper, we provide evidence on the relative performance of these two classes of models. Using a sample of 2860 quarterly CDS spreads we find that a model of distress using accounting metrics performs comparably to market-based structural models of default. Moreover, a model using both sources of information performs better than either of the two models. Overall, our results suggest that both sources of information (accounting- and market-based) are complementary in pricing distress.
ISSN: 0378-4266