Disentangling and Assessing Uncertainties in Multiperiod Corporate Default Risk Predictions

TL;DR

This paper develops a comprehensive framework to quantify uncertainties in corporate default risk predictions by integrating diverse data sources and disentangling multiple contributing factors, with practical implications for market risk evaluation.

Contribution

It introduces a novel procedure for assessing uncertainties in default risk predictions, combining historical, financial, and macroeconomic data through parsimonious models and advanced computational methods.

Findings

Uncertainty levels in default risk predictions are substantial.

Uncertainty correlates with default risk levels, offering insights for risk management.

The method effectively predicts total defaults and assesses market credit risk.

Abstract

Measuring the corporate default risk is broadly important in economics and finance. Quantitative methods have been developed to predictively assess future corporate default probabilities. However, as a more difficult yet crucial problem, evaluating the uncertainties associated with the default predictions remains little explored. In this paper, we attempt to fill this blank by developing a procedure for quantifying the level of associated uncertainties upon carefully disentangling multiple contributing sources. Our framework effectively incorporates broad information from historical default data, corporates' financial records, and macroeconomic conditions by a) characterizing the default mechanism, and b) capturing the future dynamics of various features contributing to the default mechanism. Our procedure overcomes the major challenges in this large scale statistical inference problem and makes it practically feasible by using parsimonious models, innovative methods, and modern computational facilities. By predicting the marketwide total number of defaults and assessing the associated uncertainties, our method can also be applied for evaluating the aggregated market credit risk level. Upon analyzing a US market data set, we demonstrate that the level of uncertainties associated with default risk assessments is indeed substantial. More informatively, we also find that the level of uncertainties associated with the default risk predictions is correlated with the level of default risks, indicating potential for new scopes in practical applications including improving the accuracy of default risk assessments.