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A Simple Measure of Default-Risk Based on Endogenous Credit-Risk Models

Both empirically and theoretically, corporate default is associated with depressed equity prices and poor financial conditions. We show that the default event defined by Leland-type endogenous credit risk models, a sufficiently low asset value, can likewise be described by a low ratio of the equity price to the firm's negative net cash-flow (i.e., debt service and negative earnings). Hence, we provide a rationale to study credit risk based on equity prices, the debt service calendar, and negative earnings, which, importantly, are readily available (if only with lags), instead of assets values and their endogenous default boundary. To track default risk, we just need to track this ratio; credit risk is the probability that this ratio becomes small.