An Empirical Test of Option Based Default Probabilities using Payment Behavior and Auditor Notes

Abstract

This paper empirically tests the hypotheses from the Black and Scholes, Merton framework (BSM) concerning the probability of default. Payment behavior and auditor notes are used as proxy variables for financial distress. The results show that the standard deviation of equity is the most significant parameter when predicting financial distress, but also the equity ratio (equity to total assets) has a significant influence. An increase in the volatility of equity increases the probability of distress, while an increase in the equity ratio reduces this probability. The expected return on equity and time horizon of debt have little effect on financial distress in our empirical model. The results gives support for using the BSM model in credit risk applications.