Market Models vs. Accounting Models - Default prediction during the financial turmoil

Abstract: During the past few years we have experienced an extraordinary turbulence in the financial markets. Stock markets in free fall, countless of bankruptcies and government interventions to save huge financial institutions have been regular events. During these times the focal point has been risk management. Poor risk management has been one of the main reasons for the experienced crisis. To be able to manage the credit risk, the lender need to have a good idea on how likely the borrower is to default. There are a number of different models available to estimate the likelihood of a borrower defaulting. We have examined two models using different sort of input when predicting default: the famous z-score by Altman’s from 1968 uses date collected from companies’ financial statements and a modified Merton model, where the input are obtained from the financial markets. The modified Merton, created by Byström (2005) model is built on Merton’s (1974) model. Our test recognized the modified Merton model to be more accurate than the original z-score model and should therefore preferable be used in an economy with highly volatile and uncertain financial markets.