The purpose of this article is to discuss a Black‐Scholes‐Merton (BSM)‐based market approach to quantify the default risk of publicly‐listed individual companies.
Using the contingent claim approach, a framework is presented to optimally use stock market and balance sheet information of the company to predict its probability of failure as well as ordinal risk ranking over a horizon of one year.
By applying the methodology, yearly estimates of the risk neutral and real probability of default for 150 Indian corporates from 1998 to 2005 were constructed, that give up‐to‐date point‐in‐time perspective of their risk assessment. It was found that option model can provide ordinal ranking of companies on the basis of their default risk which also has good early warning predictability.
The option‐based default probability estimation may be an innovative approach for measuring and managing credit risk even in the emerging market economy. The asset value model developed in this paper based on the BSM model can facilitate the Indian banks as well as investors to get an early warning signal about the company's default status.
