Validation of Corporate Probability of Default Models Considering Alternative Use Cases

In this study, we consider the construction of through-the-cycle (“TTC”) PD models designed for credit underwriting uses and point-in-time (“PIT”) PD models suitable for early warning uses, considering which validation elements should be emphasized in each case. We build PD models using a long history of large corporate firms sourced from Moody’s, with a large number of financial, equity market and macroeconomic variables as candidate explanatory variables. We construct a Merton model-style distance-to-default (“DTD”) measure and build hybrid structural reduced-form models to compare with the financial ratio and macroeconomic variable-only models. In the hybrid models, the financial and macroeconomic explanatory variables still enter significantly and improve the predictive accuracy of the TTC models, which generally lag behind the PIT models in that performance measure. We conclude that care must be taken to judiciously choose the manner in which we validate TTC vs. PIT models, as criteria may be rather different and be apart from standards such as discriminatory power. This study contributes to the literature by providing expert guidance to credit risk modeling, model validation and supervisory practitioners in controlling the model risk associated with such modeling efforts.

Determinants of Sukuk Issuers’ Financial Stability: Evidence from Malaysia

Financial stability and Sukuk expanded swiftly into the financial industry after the 2007-2008 global financial turmoil. Malaysia's Sukuk market is arguably the most prominent in Islamic finance globally, and its inherent nature gives it a better security on the premise of guaranteed firms’ financial stability and returns to investors. This study aims to explore the extent of the Malaysian firms’ financial stability are being influenced by the characteristics of Sukuk and also the firms’ characteristics. Sixty-one listed companies that have issued Sukuk from 1997 to 2017 have been selected for this study. The nave distance to default (DD) developed by Bharath and Shumway was used as a measure of the firms’ financial stability. Ordinary Least Squares (OLS) was employed in this study, and the results confirmed that Sukuk could promote the firms’ financial stability. The variables related to the characteristics of Sukuk that were found to influence financial stability were the intensity of Sukuk and the proportion of Sukuk financing. The firm size, valuation, solvency, and profitability were the firms’ characteristics that have also affected the firms’ financial stability significantly. All these provide evidences that Malaysia should play more active role in promoting the development of Sukuk market, and at the same time should be aware that financial stability is a systematic element which involved many complex factors.

Financial Distress, the Severity of Financial Distress and Direction of Earnings Management: Evidences from Indian Economy

This paper investigates the relationship between earnings management and financial distress and considers whether this relationship varies based on the severity of financial distress and signs of discretionary accruals (a proxy for earnings management). For this purpose, multiple regression analysis has been employed on a sample of 192 financially distressed Indian firms during the period 2011–2018, counting to 1,272 firm-year observations. Discretionary accruals are estimated by the Modified Jones model and Raman and Shahrur (2008) model, while Altman’s Z-score and distance-to-default model are used to detect the degree of financial distress. The findings disclose that the low distressed firms are indulged in higher earnings management than high distressed firms. Also, the low distressed firms are engaged more in income-decreasing earnings management. However, the results are not consistent across both earnings management and distress measures. The findings have significant implications for investors and creditors. They need to be aware of this fact while evaluating creditworthiness of a firm since firms with even a low degree of financial distress can indulge in earnings management to camouflage their true financial condition.

PROBABILITY OF DEFAULT MEASUREMENT MODELS OF MERTON ON SHARIAH BANKS AND CONVENTIONAL BANKS IN INDONESIA FOR 2011-2017 PERIOD

This paper provides empirical evidence of the comparison default risk in Islamic banks and conventional banks in Indonesia over the 2011 to 2017 period. The calculation of bank default risk using a Merton Model has allowed the measure of the Distance-to-Default (DD) and Default probability (DP). This study was extended to investigate the differences of bank default risk between Islamic banks and conventional banks with the employ of T-test. The evidence shows Islamic banks as banks that are far from the Possibility of Default Risk rather than conventional banks. The T-test indicates that there are significant differences in the Probability of Default values between Islamic banks and conventional banks. These findings could be relevance to regulators in Indonesia to support the growth of Islamic, which helps in maintaining financial system stability and avoiding systemic risk.

THE BANKRUPTCY RISK IN INFRASTRUCTURE SECTORS: AN ANALYSIS FROM 2006 TO 2018

ABSTRACT Purpose: This research aims to identify the probability of default of infrastructure companies considering the sector specificities of their activities. In addition, the work seeks to identify the application of structural variables of probability of default in a model in a reduced way in order to identify the significance of its use. For this purpose, we investigated 1,520 North American companies from six different sectors linked to infrastructure. Originality/value: The analyzes carried out to identify the probability of a company going bankrupt hardly consider its sectorial particularity. Although most models bring important inputs for risk assessment, most of them do not consider this sectoral view. Then, this work has as value and originality the contribution to fill this gap and identify the existence of sectorial differences in the analysis of default risk in infrastructure companies in the North American market in the period between 2006 and 2018. Design/methodology/approach: The study performed a logistic regression (logit model) using 11 model variables established in calculating the probability of default. It also used the variable distance to default as an explanatory variable in order to identify its ability to explain the researched phenomenon. Findings: The study identified that, in addition to the size of the companies, the distance to default variable is the only variable that can be applied with significance in all the analyzed sectors. In addition, it was identified that companies in the oil and gas sector have less sensitivity to this variable than companies in the other sectors.

Sustainable Disclosure Policies and Sustainable Performance of European Listed Companies

Sustainable disclosure has become common for companies to publicly signal their responsible behavior. Our research idea is twofold. First—irrespective of its content—better quality sustainable disclosure should identify more sustainability compliant companies. Second, we propose that those companies should have a more stable—and thus more sustainable—performance. Focusing on the top-capitalized companies of the EU-28 stock exchanges, we assess how GRI sustainable-reporting quality associates with stock-price volatility and distance-to-default. Our results, which resist various robustness checks, confirm that better quality sustainable disclosure couples with more sustainable performance. Thus, pro-disclosure policies could enhance long-term value creation.

Impact of Credit Risk on Momentum and Contrarian Strategies: Evidence from South Asian Markets

We examine the profitability of the momentum and contrarian strategies in three South Asian markets, i.e., Bangladesh, India, and Pakistan. We also analyze, whether credit risk influences momentum and contrarian return for these markets from 2008 to 2014. We use default risk that relates to non-payments of debts by firms as a measure of credit risk. For that purpose, we use distance to default (DD) by Kealhofer, McQuown, and Vasicek (KMV) model as a proxy of credit risk. We calculate the credit risk and form the momentum and contrarian strategies of the firms based on high, medium, and low risk. We find that in all three markets, the momentum and contrarian returns are significant for medium and high credit risk portfolios and no momentum and contrarian returns for low credit risk portfolios.

Impact of Credit Risk on Momentum & Contrarian Strategies: Evidence from South Asian Markets

We examine the profitability of the momentum and contrarian strategies in three South Asian markets i.e. Bangladesh, India and Pakistan. We also analyze, whether credit risk influences momentum and contrarian return for these markets from 2008 to 2014. We use Distance-to-default (DD) of Kealhofer, McQuown and Vasicek (KMV) model as a measure of credit risk. We calculate the credit risk and form the momentum and contrarian strategies of the firms on the basis of high, medium and low risk. We find that in all three markets, the momentum and contrarian returns are significant for medium and high credit risk portfolios and no momentum and contrarian returns for low credit risk portfolios.