Firm-Specific Credit Risk

Since the the New Basle Capital Accord sets up in 1998,credit risk model has been a very important issue both in the theoretical and practical area.This paper proposes a path-dependent barrier option framework instead of the common European call option in the classical Merton's approach.We argue for the inclusion of a firm-specific early bankruptcy barrier so as to reflect the nature of many bankruptcy codes,jurisdictions and covenants,which allow bondholders to extract value when some trigger event occurs.The inclusion of such a barrier is also necessary from an investment policy point of view to account for bounded managerial risk choices.We estimate the parameters of the model with maximum likelihood estimation,and calculate the theoretical expected probability of default to assess the credit risk of the listed company.We provide empirical validation of the model and find evidence that the implied default barriers are statistically significant for a sample of mechanical and other industry firms in China over the period 2001-2008.By treating the event of being Special Treatment as the proxy event of default,we discuss the validation of predication and explanation of our model and find that our model can distinguish the ST companies and non-ST companies.At last,we compare the prediction power of the expected default probability of our model with the Merton's and KMV's Default Distance,and find evidence that our model experiences some advantage over other models when we choose the lower quintiles as our critical value.