Predictions of Default Probabilities in Structural Models of Debt

by Hayne E. Leland of the University of California, Berkeley

April 22, 2004

Introduction: This paper examines the default probabilities (DPs) that are generated by alternative "structural" models of risky corporate bonds.1 We have three objectives:

1. To distinguish "exogenous default" from "endogenous default" models

2. To compare these models' predictions of default probabilities, given common inputs

3. To examine of how well these models capture actual average default frequencies, as reflected in Moody's (2001) corporate bond default data 1970-2000.

Our analysis is limited to structural models of debt and default. These models assume that the value of the firm's activities ( "asset value") moves randomly through time with a given expected return and volatility. Bonds have a senior claim on the firm's cash flow and assets. Default occurs when the firm fails to make the promised debt service payments.

JEL Classification: G00.

Keywords: Default frequencies, structural models, credit risk.

Published in: Journal of Investment Management, Vol. 2, No. 2, (Q2 2004), pp. 5-20.

Previously titled: Predictions of Expected Default Frequencies in Structural Models of Debt

This paper is republished as Ch.2 in...

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Related reading:

• PRINCETON LECTURES 1: Pros and Cons of Structural Models: An Introduction

• PRINCETON LECTURES 2: A New Structural Model

• PRINCETON LECTURES 3: Financial Synergies and the Optimal Scope of the Firm: Implications for Structured Finance