2: Explaining credit ratings of Australian companies--an application of the Merton model.(Report)

Abstract:

This paper examines how the default likelihood indicator computed from the option-based 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.

Keywords:

DEFAULT RISK," CREDIT RATINGS; ORDERED PROBIT.

1. Introduction

Credit risk is perceived as the oldest and most important risk in the financial system and the development of credit-risk modeling can be traced back to the seminal work of Beaver (1966), who finds significant differences in financial ratios between bankrupt and nonbankrupt firms. Since his work, the number of credit-risk modeling studies has surged. An accounting-based credit-scoring model is one strand of credit-risk models which employs different statistical approaches to quantify corporate bankruptcy. By heavily relying on accounting variables, these statistical models categorize firms into two groups: nonbankrupt and bankrupt. Examples include Altman (1968), Altman, Haldeman, and Narayanan (1977), Ohlson (1980), Zmijewski (1984), and Shumway (2001). Another strand of credit-risk models is based on the option-pricing theory of Black and Scholes (1973). For example, Merton (1974) shows that the firm default probability can be estimated using an option-pricing model. By employing the Merton model, Vassalou and Xing (2004) find that the default likelihood indicator (DLI) can capture the default risk. In addition, they suggest that firm size and book-to-market ratio are default-related factors. Moreover, Hillegeist, Keating, Cram and Lundstedt (2004) find that the performance of the Merton model in explaining firm bankruptcies is superior to those of the two accounting models, namely Altman's (1968) Z-Score and Ohlson's (1980) O-score models. For Australian evidence, Gharghori, Chan and Faff (2006) evaluate the performance of three alternate default-risk models using logistic regression approach. The first two models that they examine are option-based model and derived from Merton (1974) model while the last model is accounting-based model and similar to Altman's (1968) Z-Score model. They find that option-based models clearly outperform the accounting-based model.

Essentially, credit ratings have been used as a tool to indicate the credit risk of corporate firms for many decades. A corporation with a high credit rating can issue a bond at a good price with more flexible options. Due to the fact that credit ratings play a significant role in financing and investment decisions, there are many studies attempting to predict credit ratings assigned by a rating agency. For example, Horrigan (1966), Pogue and Soldofsky (1969), Pinches and Mingo (1973), and Kaplan and Urwitz (1979) (1) investigate the effectiveness of accounting-based models in explaining credit ratings using U.S. data. Moreover, Blume, Lim and MacKinlay (1998) examine whether there is a shift in rating standards over time by employing an ordered probit approach. They document that the decline in credit quality of U.S. corporate bonds over the last few decades may arise from the use of more stringent standards in assigning ratings. While the aforementioned papers have examined the credit ratings in the U.S. market, Gray, Mirkovic, and Ragunathan (2006) is the only study that investigates the relationship between firm ratings and accounting and industry variables in Australia. They demonstrate that interest coverage and leverage ratios have the most pronounced effect on credit ratings.