What Triggers Default? A study of the default boundary
by Sergei A. Davydenko of the University of Toronto
November 15, 2010
Abstract: In structural models of risky debt default is triggered when the market value of the firm's assets falls below a certain solvency boundary. Based on market values of defaulting firms, I estimate the default boundary to be 66% of the face value of debt, and find support for models in which the default timing is chosen endogenously to maximize the value of equity. Although default predictions based entirely on solvency can match observed average default frequencies, they misclassify a substantial number of firms in cross-section, affecting the accuracy of boundary-based models. In particular, cash shortages play an important independent role in triggering default, but only when access to external financing is restricted.
Keywords: Credit risk, Default boundary, Insolvency, Cash shortage, Default
Previously titled: When Do Firms Default? A Study of the Default Boundary