Forecasting Default in the Face of Uncertainty

We give an empirical assessment of I2, a structural credit model based on incomplete information. In this model, investors cannot observe a firm’s default barrier. As a consequence, I2 exhibits both the economic appeal of a structural model and the tractable pricing formulae and empirical plausibility of a reduced form model. We compare default probability and credit spread forecasts generated by I2 and the wellknown structural models of Merton (1974) and Black & Cox (1976). We find that I2 reacts more quickly to new information and, unlike the other two models, it forecasts positive short term credit spreads. ∗School of Operations Research and Industrial Engineering, Cornell University, Ithaca, NY 14853-3801, USA, Phone (607) 255 9140, Fax (607) 255 9129, email: [email protected], web: www.orie.cornell.edu/∼giesecke. Financial support by Deutsche Forschungsgemeinschaft is gratefully acknowledged. †Barra, Inc., 2100 Milvia Street, Berkeley, CA 94704-1113, USA, Phone (510) 649 4601, Fax (510) 848 0954, email [email protected]. ‡The data for the empirical studies was generously supplied by Barra, Inc. We would like to thank Greg Anderson, Tim Backshall, Roveen Bhansali, Ursula Gritsch, Guy Miller and Vijay Poduri for their contributions to this article. We are grateful to Stephen Figlewski and to an anonymous referee for their insightful reviews.