The magnitude and Cyclical Behavior of Financial Market Frictions

Default probabilities. Our measure of the probability that a firm in our sample will
default within a certain period of time comes from the Moody’s∣K∙M∙V Corporation
(MKMV). The theoretical underpinnings to these probabilities of default are provided
by the seminal work of Merton (1973, 1974). According to this option-theoretic
approach, the probability that a firm will default on its debt obligations at any point
in the future is determined by three major factors: the market value of the firm’s
assets, the standard deviation of the stochastic process for the market value of assets
(i.e., asset volatility), and the firm’s leverage. These three factors are combined into
a single measure of default risk called distance to default, defined as

In theory, the default point should equal to the book value of total liabilities,
implying that the distance to default compares the net worth of the firm with the
size of a one-standard-deviation move in the firm’s asset value.¹⁴ The market value
of assets and the volatility of assets, however, are not directly observable, so they
have to be computed in order to calculate the distance to default. Assuming that the
firm’s assets are traded, the market value of the firm’s equity can be viewed as a call
option on the firm’s assets with the strike price equal to the current book value of
the firm’s total debt.¹⁵ Using this insight, MKMV “backs out” the market value and
the volatility of assets from a proprietary variant of the Black-Scholes-Merton option
pricing model, employing the observed book value of liabilities and the market value
of equity as inputs; see Crosbie and Bohn (2003) for details.

In the final step, MKMV transforms the distance to default into an expected
probability of default—the so-called expected default frequency (EDF)—using an
empirical distribution of actual defaults. Specifically, MKMV estimates a mapping
relating the likelihood of default over a particular horizon to various levels of distance
to default, employing an extensive proprietary database of historical defaults and

¹⁴ Empirically, however, MKMV has found that most defaults occur when the market value of
the firm’s assets drops to the value equal to the sum of the firm’s current liabilities and one-half of
long-term liabilities (i.e., Default Point = Current Liabilities + 0.5 × Long-Term Liabilities), and the
default point is calibrated accordingly.

¹⁵The assumption that all of the firm’s assets are traded is clearly inappropriate in most cases.
Nevertheless, as shown by Ericsson and Reneby (1999), this approach is still valid provided that at
least one of the firm’s securities (e.g., equity) is traded.

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