Jens Hilscher and Mungo Wilson Propose a New Measure of Systematic Credit Risk

Nov. 21, 2016

The study shows that a straightforward and easy-to-implement and interpret measure of default probability contains significantly more information about future default and failure than S&P corporate credit ratings. Jens Hilscher and Mungo Wilson propose a new measure of systematic credit risk, the tendency for firms to default in bad times, just when the marginal investor is least able to absorb losses. They provide a theoretical justification for the measure, which they call failure beta, and show that ratings contain information about systematic default risk, which is also reflected in credit default swap (CDS) spreads.

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Abstract

This paper investigates the information in corporate credit ratings. If ratings are to be informative indicators of credit risk, they must reflect what a risk-averse investor cares about: both raw default probability and systematic risk. We find that ratings are relatively inaccurate measures of raw default probability—they are dominated as predictors of failure by a simple model based on publicly available financial information. However, ratings do contain relevant information since they are related to a measure of exposure to common (and undiversifiable) variation in default probability (“failure beta”). Systematic risk is shown to be related to joint default probabilities in the context of the Merton [Merton RC (1974) On the pricing of corporate debt: The risk structure of interest rates. J. Finance 29(2):449–470] model. Empirically, it is related to credit default swap spreads and risk premia. Given the multidimensional nature of credit risk, it is not possible for one measure to capture all the relevant information.