Assessing Credit Quality From The Equity Market: Can Structural Approach Forecast Credit Ratings?

The paper investigates the empirical performance of default probability prediction based on Merton's (1974) structural credit risk model. More specifically, it studies if Merton's default measure, represented by distance-to-default, is a sufficient statistic to reflect the equity market information concerning the credit quality of the debt-issuing firm. Employing the same information set, it's seen that a simple reduced form model outperforms the Merton (1974) type of models for both in-sample fitting and out-of-sample predictability for credit ratings. Although structural models are theoretically sound and distance-to-default is an important factor that determines the credit quality of the debt-issuing firm, it does not adequately capture all the information from the equity market concerning the firm's credit quality.