A Clinical Study of the Probability of Default for Global Financial Firms Affected by the Subprime Mortgage Crisis

This article presents a modification of Merton's (1976) ruin option pricing model to estimate the implied probability of default from stock and option market prices. To test the model, we analyze all global financial firms with traded options in the U.S. over the period December 1996 through October 2008, with a special focus on the subprime mortgage crisis period. We compare the performance of the implied probability of default from our model to the expected default frequencies based on the KMV model and agency credit ratings by constructing cumulative accuracy profiles (CAP) and the receiver operating characteristic (ROC). We find that the probability of default estimates from our model are equal or superior to other credit risk measures studied based on CAP and ROC. In particular, during the subprime crisis our model surpassed credit ratings and matched or exceeded KMV in anticipating the magnitude of the crisis. An important benefit of our model over other methods is that it is a forward-looking measure that uses a range of option prices and does not rely on historical data