The financial health of a company and the risk of its default: Back to the future

TL;DR

This paper develops an equilibrium model linking a company's financial health to default risk, using forward-looking probability of default estimates based on financial forecasts and credit conditions.

Contribution

It introduces a novel equilibrium framework that estimates default probabilities considering forecast credibility and market conditions, enhancing risk assessment methods.

Findings

Model estimates idiosyncratic default risk.

Provides forward-looking probability of default.

Establishes interest rate ranges based on performance and credit supply.

Abstract

We theorize the financial health of a company and the risk of its default. A company is financially healthy as long as its equilibrium in the financial system is maintained, which depends on the cost attributable to the probability that equilibrium may decay. The estimate of that probability is based on the credibility and uncertainty of the company's financial forecasts. Accordingly, we develop an equilibrium model establishing ranges of interest rates as a function of predictable corporate performance and of its credit supply conditions. As a result, our model estimates idiosyncratic default risk and provides intrinsically forward-looking PD.