Credit Rating or Probability of Default from Financial Ratios

Question

Does anyone know of any papers about credit rating development or probability of default estimation done based on financial ratios that also include methodology and maybe good/bad criteria?

Something like they have some financial ratios and then they have some methodology that reduces it to a few financial ratios and then they make a regression model out of it or something.

Answer 1

Most of the papers concern CDS spreads which you will need to convert to a PD.

Paper using country specific fundamentals: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2517018

This paper uses leverage: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2361872

Another one that decomposes them against peer groups: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2413011

Comparing spreads and ratings: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1551406

Answer 2

I am also not aware of any papers in this area. But having developed many such models, I can list the important steps:

1. Decide on the target variable: usual choices are historical default data, agency ratings and expert rankings
2. Create a sample containing the possible predictors
3. Reduce the list with the help of some expert, e.g. exclude all the predictors deemed to be irrelevant
4. Analyse the predictors standalone, e.g. with a rank correlation
5. Discuss the poor predictors with the experts and possibly eliminate some. At this stage one usually has about 10 to 20 predictors
6. Run regression analyses ((ordinal) logistic regression) after standardisation with all the possible combinations (e.g. consider combinations with at most 8 factors and more than 2 predictors).
7. Check for each combination: the coefficients are intuitive (e.g. higher asset/debt better the rating etc.) and that they are high enough (e.g. more than 5% weight).
8. List e.g. top 10 models using rank correlation and discuss them with the experts.

Answer 3

Bloomberg has a Default Risk model, which is similar to what you are querying. You can see a screenshot in this PDF. There you can also see the kind of variables they use.

You can access it by typing DRSK at the CDS screen is Bloomberg. (If the screenshot in the PDF is not clear enough, let me know and I can post one with better resolution from Bbg)

This model uses fundamental data, and obviously they have calibrated and backtested it; however it is a proprietary model, therefore you might have a hard time finding the details. You can try googling for it, there might be a white paper on it.

Answer 4

Altman Z Score - http://en.wikipedia.org/wiki/Altman_Z-score - From Wikipedia - "The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.