Measuring the default risk of Sukuk holders for shariah compliance companies in Malaysia: Using Merton's model with maximum likelihood estimator

Abstract

The purpose of this paper is to measure the default probability of Malaysian companies which have issued Sukuk for the period 2001 to 2010 by using Merton's Model. Maximum Likelihood Estimation (MLE) method has been used in the computation of the unavailable parameters of the Merton's Model which are the market value of the company's asset, the volatility and the asset expected return. Findings show that Sukuk with high default risk earns higher returns than Sukuk with low default risk. The rating of the Sukuk supports the result of the default probability whereby most of the Sukuk with high probability of default were rated low. This study finds the default probability measured from Merton's Model can explain the credit ratings of the Sukuk. Ordered probit model has been used to examine the effectiveness of the market based model in explaining credit ratings as compared to the accounting based model. By incorporating Merton's default probability model with two other related default risk factors (issuer size and book-to-market ratio), the model is found to have outperformed accounting-based model in explaining Sukuk credit ratings.