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Journal of Financial Stability 3 (2007) 85–131

A market-based framework for bankruptcy prediction
Alexander S. Reisz a,∗ , Claudia Perlich b,1 a U.S. Treasury Department, Office of the Comptroller of the Currency, 250 E Street SW, Mail Stop 2-1,
Washington, DC 20219, United States b Data Analytics Research Group, IBM T.J. Watson Research Center, 1101 Kitchawan Road,
Route 134, P.O. Box 218, Yorktown Heights, NY 10598, United States
Received 12 October 2006; received in revised form 16 February 2007; accepted 20 February 2007
Available online 28 February 2007

Abstract
We estimate probabilities of bankruptcy for 5784 industrial firms in the period 1988–2002 in a model where common equity is viewed as a down-and-out barrier option on the firm’s assets. Asset values and volatilities as well as firm-specific bankruptcy barriers are simultaneously backed out from the prices of traded equity.
Implied barriers are significantly positive and monotonic in the firm’s leverage and asset volatility. Our default probabilities display better calibration and discriminatory power than the ones inferred in a standard
Black and Scholes [Black, F., Scholes, M., 1973. The pricing of options and corporate liabilities. J. Pol.
Econ. 81, 637–659]/Merton [Merton, R.C., 1974. On the pricing of corporate debt: the risk structure of interest rates. J. Finance 29, 449–470] and KMV frameworks. However, accounting-based measures such as Altman Z- and Z -scores outperform structural models in 1-year-ahead bankruptcy predictions, but lose relevance as the forecast horizon is extended.
© 2007 Elsevier B.V. All rights reserved.
JEL classification: G13; G33
Keywords: Probability of default; Structural models; Barrier option; Discriminatory power; Recalibration

1. Introduction
The purpose of this paper is two-fold. First, we estimate default probabilities for close to 6000 industrial firms in the period 1988–2002, refining the estimation procedure within a structural
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