An empirical estimation of the default risk of Chinese listed company based on the Merton-KMV Model

Abstract

This paper calculates the “Default Likelihood Indicators” (DLI) for Chinese listed companies by using the Merton-KMV model during the period from 2000 to 2010 and examines the predictive power the of the Merton-KMV model. We construct some logit regression models and regress the indicator of default on DLI and other variables that may be important in predicting default. The results reveal that Merton-KMV is a significant model to predict default in Chinese market, however it is not a sufficient model since we can improve the predictive performance of the Merton-KMV model by adding financial ratios measuring profitability, leverage and liquidity. In addition, it is found that the functional form of the Merton-KMV model adds value to that of the inputs for the model. Finally we draw the power curve for the Merton-KMV model, the pure accounting model and a hybrid model that combine DLI calculated from the Merton-KMV model and financial ratios measuring profitability, leverage and liquidity. We find that the hybrid model outperforms the other two models and the accounting model is the weakest one.