Explaining Credit Ratings of Australian Companies—An Application of the Merton Model

Abstract

This paper examines how the default likelihood indicator computed from the optionbased model of Merton (1974) together with two default-related factors, namely firm size and book-to-market ratio, effectively explain credit ratings when compared to accounting ratios. Using Australian companies that are rated by Standard and Poor's during 1992-2003 and ordered probit analysis we find that the market-based model is more informative in explaining credit ratings than the accounting-based model.

Examining What Best Explains Corporate Credit Risk: Accounting-Based Versus Market-Based Models

“…Demirovic and Thomas (2007) find that although distance-to-default is the most significant single variable for the measurement of corporate credit risk, market-based models exhibit better performance if accounting data are included. Tanthanongsakkun and Treepongkaruna (2008) and Das et al (2009) reach similar conclusions.…”

Dynamic forecasts of financial distress of Australian firms

“…Variables are selected from the recent major studies by Sobehart and Stein (2000), Shumway (2001), Chava and Jarrow (2004), Campbell et al (2008) and Fitzpatrick and Ogden (2011). As this study was conducted based on Australian data, some variables that were found to have been useful in Australian studies are also included (from Castagna and Matolcsy, 1981; Gharghori et al, 2006, 2009; Hensher and Jones, 2007; Jones and Hensher, 2004; Tanthanongsakkun and Treepongkaruna, 2008). A set of fundamental accounting-based and market-based variables chosen from the aforementioned studies is shown in Table 2.…”

“…Consistent with Campbell et al (2008), Griffin and Lemmon (2002) and Fitzpatrick and Ogden (2011) find that low BM (high MB) is associated with an increase in default risk. However, the Australian evidence of Gharghori et al (2006Gharghori et al ( , 2009 and Tanthanongsakkun and Treepongkaruna (2008) is that firms with high BM (low MB) have a higher default risk. 13 The size measure used in this study is the value of the company relative to the value of all companies listed on the ASX.…”

“…While there are several recent Australian studies examining the risk of financial distress, most of them have focused on the use of the logit model (Gharghori et al, 2006; Hensher and Jones, 2007; Jones and Hensher, 2004), the probit model (Gray et al, 2006) and the Merton’s option-based model (Allen and Powell, 2012; Gharghori et al, 2006, 2009; Tanthanongsakkun and Treepongkaruna, 2008).…”

A Comparison of Corporate Bankruptcy Models in Australia: The Merton vs. Accounting-based Models

“…Specifically, sets of financial variables from Altman (1968), Zmijewski (1984), and Shumway (2001) as well as the default likelihood indicator (DLI) computed by the Merton model are used as explanatory variables in the study to quantify corporate failure. Using logistic regression analysis, the parameters of each 1 Tanthanongsakkun and Treepongkaruna (2007) also report that the Merton based model is superior to the traditional accounting based model in an Australian context. 2 In this paper, we use the following words interchangeably: financial distress, bankruptcy, default, insolvency and failure.…”