Can J Adm Sci
Copyright © 2007 ASAC. Published by John Wiley & Sons, Ltd.
Assessing Credit Quality from the
Equity Market: Can a Structural
Approach Forecast Credit Ratings?
RBC Financial Group
Canadian Journal of Administrative Sciences
Revue canadienne des sciences de l’administration
24: 212–228 (2007)
Published online 29 August 2007 in Wiley Interscience (www.interscience.wiley.com). DOI: 10.1002/CJAS.27
We are grateful for the comments and suggestions from the Editor, Jason Wei, and the two anonymous referees, as well as Edward Altman, Darrel
Duffi e, Kim Huynh, Louis Gagnon, Lew Johnson, Frank Milne and Lynnette Purda. Financial support from SSHRC and Queen’s School of Business
are gratefully acknowledged.
*Please address correspondence to: Wulin Suo, School of Business, Queen’s University, 99 University Avenue, Kingston, Ontario, Canada K7L 3N6.
We investigate the empirical performance of default
probability prediction based on Merton’s (1974) struc-
tural credit risk model. More specifi cally, we study if
distance-to-default is a suffi cient statistic for the equity
market information concerning the credit quality of the
debt-issuing fi rm. We show that a simple reduced form
model outperforms the Merton (1974) model for both
in-sample fi tting and out-of-sample predictability for
credit ratings, and that both can be greatly improved by
including the fi rm’s equity value as an additional vari-
able. Moreover, the empirical performance of this hybrid
model is very similar to that of the simple reduced form
model. As a result, we conclude that distant-to-default
alone does not adequately capture the fi rm’s credit
quality information from the equity market. Copyright ©
2007 ASAC. Published by John Wiley & Sons, Ltd.
JEL Classifi cation: G13, G33
Keywords: Credit rating, default probability, distance-
to-default, structural credit risk model
Dans cet article, nous évaluons la performance