Ex Ante Estimation of a Firm's Distress Risk Parameters from Bond Transaction Data

Abstract

In this paper, we exploit the information in a publicly traded company’s stock and bond prices to es-timate its default probability and recovery rate. We document that estimated probabilities of default and recovery rates exhibit cross-sectional variation with the ratio of book to market equity and with industry affiliation. Additionally, dividend yield, and the term premium in Treasury bond yields influ-ence temporal variation in aggregate probabilities of default and in recovery rates. Such findings provide a deeper understanding of how default probability and recovery rate interact to determine the outcome when a firm ends up in financial distress.

TOPICS: Fixed-income portfolio management, credit risk management, fundamental equity analysis, statistical methods