Implied Bankruptcy Prob - Merton Based

Electronic copy available at: http://ssrn.
com/abstract=773844
An Analysis of the Implied Probability of Bankruptcy for Chapter
11 Firms and Global Banks Impacted by the Subprime Crisis
Abstract
This article presents a modication of Mertons (1976) ruin option pricing model to estimate the
implied probability of bankruptcy from stock and option market prices. Our model is important to
the literature on measuring bankruptcy and default probabilities because it yields daily estimates
of bankruptcy risk. To test our model, we analyze the impact of the subprime mortgage crisis on
global banking institutions and other rms over the period January 2007 to May 2008. We nd a
dramatic increase in the probability of bankruptcy for these groups. For example, the bankruptcy
probability for Bear Stearns reaches 30 percent on March 12, 2008; Fannie Maes probability reaches
46% on March 18, 2008; and the probability for UBS is 35 percent on March 20, 2008. We also
estimate the model for 109 large rms that led Chapter 11 bankruptcy over the period 1998-2006.
The mean delta for the Chapter 11 ling group is 24.5 percent versus 1.9 percent for S&P 500 rms.
Furthermore, our bankruptcy estimates are on average consistent with z-scores, debt ratings, and
equity ratings, but we are able to anticipate increases of specic bankruptcy probabilities in cases
where ratings remain unchanged.
1
Electronic copy available at: http://ssrn.com/abstract=773844
1 Introduction
Corporate bankruptcy is central to the theory of the rm. As pointed out by Jensen and
Meckling (1976) the legal denition of bankruptcy is dicult to specify precisely. In general,
it occurs when the rm cannot meet a current payment on a debt obligation...In this event the
stockholders have lost all claims on the rm, and the remaining loss, the dierence between the
face value of the xed claims and the market value of the rm, is borne by the debtholders. This is
the denition of bankruptcy that we adopt in this paper. Probability of bankruptcy is the likelihood
that stockholders will walk away with nothing and the stock will lose all its value.
This paper aims to achieve several goals by presenting both theory and empirical evidence
on a contemporaneous method for estimating the implied probability of bankruptcy. We present
a modication of the Mertons (1976) ruin model and derive closed-form solutions for the price
of options written on individual stocks. Our option pricing equations depend on the probability
of bankruptcy, the volatility of the stock, and the other observables that aect the Black-Scholes
model. Since bankruptcy probability is not an observable variable, calls and puts can be inverted to
yield simultaneously the implied probability of bankruptcy and the implied volatility as functions
of the stock price, the stock option price, and other observables.
We empirically test our model on two crucial samples. First, we examine all major rms that
led for Chapter 11 bankruptcy protection in which options were traded over the period 1998-2006.
The model predicts well for this group: the mean implied bankruptcy probability for Chapter 11
rms is 24.5 percent versus 1.9 percent for Standard and Poors 500 rms. The dierence in means
of the bankruptcy probabilities is signicant at the one percent level. Our results are robust across
industries and years of the sample period. Furthermore, the implied probability of bankruptcy
is generally consistent with z-scores, senior long-term debt ratings, and common stock ratings for
sample rms.
Second, we test our model on rms impacted by the subprime crisis. The subprime crisis,
2
which began in the U.S., has had profound eects globally. Our analysis of this crisis provides
new evidence on the nancial interlinkages for bankruptcy risk of global banking institutions and
nonnancial rms. Specically, we analyze the universe of all nancial rms and selected building
construction and credit services rms with traded stock options, and the results are striking. We
nd that the average probability of bankruptcy for the whole nancial rms universe increases from
1 percent to 7 percent while the default probability for the building construction rms increases
from 1 to 15 percent. A few noteworthy examples are as follows: the bankruptcy probability for
Bear Stearns reaches 30 percent on March 12, 2008; Fannie Maes bankruptcy probability reaches 46
percent on March 18, 2008; and Countrywide Financials bankruptcy probability hits 84.5 percent
on November 20, 2007, less than two months before they were rescued through acquisition by Bank
of America. Our results illustrate the two types of channels for international transmission of the
subprime crisis: common shocks (a concurrent impact such as experienced by money center banks
globally) and spillover eects (a delayed impact, which our results show as of May 2008 is still
unfolding for regional banks both in the U.S. and globally). The spillover eect can be observed
for Banco Bradesco (Brasil) with default probability of 52.82% computed on May 27, 2008. It
could also be noted that for 15 out of 23 credit services rms, the maximum value of the default
probability is achieved after March 2008 and at the end of May 2008 there is still a noticeable
upward trend in the average default probability for that group.
Our bankruptcy risk is the ex-ante subjective bankruptcy probability embedded by the market
about the likelihood that shareholders will lose all their investment in the stock during the life of
the option. Recent nancial scandals (e.g. Enron) reported by the nancial press suggest that for
some rms this ex-ante probability might be dierent from zero and worth considering by an option
pricing model. For example, according to a ling with the SEC in June 2003, the communications
provider Genuity reports that the rm believes that its stockholders will not receive any proceeds
from the liquidation and that its common stock will have no value in connection with the liquida-
3
tion. In November, Genuity said that the [bankruptcy liquidation] plan species payments that
are to be made to the companys creditors. Stockholders will not receive any distribution under the
liquidation plan.
1
Other U.S. companies that went bankrupt where stockholders lost all their in-
vestment include Williams Communications, Cray Computer, B&M, Continental, Mortgages GAC,
and others. We examine many of these rms in our paper. Also, in agreement with these facts,
our study answers research calls, among others, by Leland (1994, p. 1221) who writes that stock
option pricing models ...need to reect...the possibility that the value of equity reaches zero with
positive probability.
Bankruptcy probabilities implied by stock and stock option prices can yield valuable insights
for at least three contexts: bankruptcy reorganization and liquidation, nancial distress and capital
structure, and risk management. Smith and Stultz (1985) have shown that rms facing bankruptcy
risk should hedge, and Brown and Toft (2002) derive the optimal hedging strategy for rms that
face bankruptcy and other deadweight costs. Hence, our paper also shares with a line of research,
represented by Altman (1968) and Altman, Haldeman, and Narayanan (1977), the recognition that
it is important to predict the possibility of bankruptcy.
2
These authors developed econometric
models that use accounting ratios and market-driven ratios to explain bankruptcy.
Another relevant strand of literature looks at equity as a barrier option on the assets of the
rm, where bankruptcy is triggered by the barrier (see Toft and Prucyk, 1997, and Brockman and
Turtle, 2003).
3
In our paper, instead of modeling the rm value, we take the stock price process as
1
Web Host Industry Review, http://thewhir.com/marketwatch/gen061203.cfm and gen112803.cfm.
2
See Altman (1993) for comprehensive reviews of this line of research.
3
Toft and Prucyk (1997) value a call option written on equity as a compound down-and-out barrier option, where
the equity process is given by the dierence between the asset and the bond processes of the rm. Brockman and
Turtle (2003) value equity as a down-and-out call option written on the assets of the rm where the strike price is
the promised future debt payment required on the bonds issued by the rm. Their closed-form valuation equations
depend on the value of the assets of the rm, rm volatility, bond parameters, the bankruptcy trigger which is linked
to rm and bond values, and other usual parameters.
4
exogenous. Hence our paper distinguishes from these works, since we propose the use of individual
stocks and options on individual stocks to obtain information on nancial distress. Neither the
value of the rm nor the value of the bonds directly aect our models.
4
In general, it is not appropriate to assume that it is possible to construct and to maintain a
continuously dynamic hedging portfolio for distressed rms and rms that have led for bankruptcy.
Hence, instead of the hedging arguments used by Black and Scholes (1973) to derive option prices,
we use equilibrium arguments similar to those of Rubinstein (1976), Brennan (1979), Stapleton and
Subrahmanyam (1984), Amin and Ng (1993), and Camara (2003) to obtain pricing formulae.
5
In
the actual world or under the actual probability measure the stock price depends on the proba-
bility of bankruptcy, a location parameter, and a scale parameter. Then using simple relations in
equilibrium, we eliminate from the option pricing equations not only preferences and the location
parameter, but also the scale parameter. These are substituted by the risk free rate of return and
the stock volatility, parameters which do not aect the process of the stock under the actual prob-
ability measure. The probability of bankruptcy does not change from the actual to the risk-neutral
world.
Overall, our model and empirical evidence illustrate potential applications of this new valuable
measure of bankruptcy risk. To present our model and ndings, we proceed as follows. Section
2 presents the assumptions underlying our theory. Section 3 derives preference-dependent pricing
equations. Section 4 obtains preference-free option pricing equations. Section 5 provides the em-
pirical tests of the model for rms that le Chapter 11 bankruptcy protection and global rms
impacted by subprime crisis. Section 6 concludes.
4
Cremers, Driessen, Maenhout, and Weinbaum (2004) and Carr and Wu (2006) use stock options as information
sources for credit default swaps.
5
Schroder (2004) derives general conditions for this equilibrium option pricing approach.
5
2 The economic framework
This section starts by presenting our assumptions on preferences and processes for consumption
and the stock price. The assumption that the stock price follows a delta-geometric random walk,
to the best of our knowledge, was not done previously in modern nance theory. Then, we use this
assumption to derive the stock-specic pricing kernel. The option pricing formulae derived in this
article is based on four assumptions.
Assumption 1 (Representative agent) There is a representative agent who maximizes:
E
t=0
U
t
(C
t
) | F
0
, (1)
where:
U
t
(C
t
) =
t
C
1b
t
/(1 b),
E is the expectations operator, U
t
(C
t
) is the utility function of consumption at date t, is the time
discount factor, b is the coecient of proportional risk aversion, and F
0
is the information set
available to the investor at date t = 0.
This paper derives prices for options at dates t (t = 0, 1, 2, ...) that mature at date T. As-
sumption 1 implies that, at t = 0, the pricing kernel implicit in option prices that mature at T is
given by the following equation:
0,T
(C
0,T
) =
U
(C
T
)
U
(C
0
)
=
T
C
T
C
0
b
. (2)
There is only one pricing kernel in the economy, which is implicit in the valuation of all
assets and is dependent on aggregate consumption. The uncertainty in this economy is driven
by the realization of two random variables at each discrete date. These are the random shocks
to consumption
c,t
and to the stock price
s,t
. The information set of the investor at date t is
represented by the algebra F
t
((
c,
,
s,
); = 0, 1, ..., t).
6
Assumption 2 (Consumption process) Aggregate consumption follows a geometric random
walk:
C
t
= C
t1
c,t
, (3)
where {
c,t
} is a sequence of independent positive random variables having the same distribution
6
such that E[ln(
c,t
) | F
0
] =
c

1
2
2
c
and V ar[ln(
c,t
) | F
0
] =
2
c
.
Assumption 2 implies that at the end of each period and, in particular, at date T consumption
C
T
is lognormally distributed:
C
T

ln(C
0
) +
c
T
1
2
2
c
T,
2
c
T
. (4)
Aggregate consumption growth, between 0 and T, has an expected or mean rate equal to
c
T
and a volatility or standard deviation equal to
c
T.
Assumption 3 (Stock price process) The stock price follows a delta-geometric random
walk:
S
t
=
0
S
t1
s,t
(5)
where {
s,t
} is a sequence of independent non-negative random variables such that:
(i) P(
s,t
= 0) =
t
,
(ii) E[ln(
s,t
) |
s,t
= 0] =
s,t

1
2
2
s,t
, V ar[ln(
s,t
) |
s,t
= 0] =
2
s,t
.
Then at the end of each period and, in particular, at date T the stock price S
T
has a delta-
lognormal distribution:
7
S
T

1
T
t=1
(1
t
), ln(S
0
) +
T
t=1
s,t

1
2
T
t=1
2
s,t
,
T
t=1
2
s,t
, (6)
6
As remarked by Rubinstein (1976), stationary consumption is not a necessary condition to price options in
discrete-time economies. However, it simplies the notation and focus the paper on the pricing of the options.
7
The delta-lognormal distribution is due to Aitchison (1955).
7
which means that:
P(S
T
< 0) = 0;
P(S
T
= 0) = 1
T
t=1
(1
t
);
P(S
T
< Z) = 1
T
t=1
(1
t
) +
T
t=1
(1
t
)
ln(S
0
) +
T
t=1
s,t

1
2
T
t=1
2
s,t
,
T
t=1
2
s,t
, Z > 0.
The expected value and the variance of stock returns, considering the distribution of S
T
given
by formula (6), are given by
8
:
E
S
T
S
0
| F
0
=
T
t=1
(1
t
)exp
t=1
s,t
, (7)
V ar
S
T
S
0
| F
0
=
T
t=1
(1
t
)exp
t=1
2
s,t
exp
t=1
2
s,t
t=1
(1
t
)
, (8)
where
s,t
is a location parameter (and not the expected return) of a delta-geometric random walk
at t. In this sense
s,t
is the scale parameter (and not the standard deviation) of a delta-geometric
random walk at t. The probability of bankruptcy up to date T is 1

T
t=1
(1
t
), while the
probability of bankruptcy at a particular date t conditional on no earlier bankruptcy is
t
. None
of these parameters is stochastic.
It should be underlined that while the assumptions involve the actual location and scale pro-
cesses of the delta-geometric random walk, neither of these variables enters into the preference-free
closed-form option pricing solutions derived in the sequel. Initially, in our economy, the stock spe-
cic pricing kernel depends on preference parameters, and the actual location and scale parameters
of the stock price. When we derive equilibrium prices for the stock and the options then there
is no arbitrage and the call-put parity holds. At this stage the location and the scale parameters
can be eliminated, i.e. they are substituted by the risk-free rate and the stock volatility. The
location parameter is eliminated from option prices when the fundamental equilibrium relation of
the economy is used in these option prices to eliminate preference parameters. The scale parameter
8
The moments of an actual delta-lognormal stochastic variable are given by Aitchison and Brown (1957, p. 95).
8
is substituted in equilibrium by the stock volatility using the relations between the lognormal and
the delta-lognormal. The probability of bankruptcy is a parameter that does not change from the
actual delta-lognormal cumulative distribution function to the risk-neutral delta-lognormal cumu-
lative distribution function.
The skewness and the kurtosis of the distribution of S
T
/S
0
, considering the distribution given
by formula (6), are given by the following equations:
Ske
S
T
S
0
| F
0
=

3
3
+ 2
1/2
(

)
3/2
, (9)
Kur
S
T
S
0
| F
0
=

6
4
3
+ 6
2
3
(

)
2
, (10)
where:
=
T
t=1
(1
t
),
= exp
t=1
2
s,t
.
The delta-lognormal distribution has no probability density function (pdf) in a rigorous sense.
However, as pointed by Dennis and Patil (1988, p. 325), the delta-lognormal has a pseudo-pdf
given by:
g(S
T
) =
1
T
t=1
(1
t
)
f
1
(S
T
) +
T
t=1
(1
t
)f
2
(S
T
)
where f
2
(S
T
) is a lognormal pdf, and f
1
(S
T
) is a dirac-delta function.
9
Assumption 4 (Bond price process) There is a zero coupon bond with the following price
process:
B
t
= e
r(Tt)
, t = 0, 1, 2, ..., T, (11)
where r is the continuously compounded interest rate and T the maturity of the bond.
9
The dirac-delta function f1(ST ) is suppose to be innite at ST = 0 and zero otherwise. It should also have
f1(ST )dST = 1. The normal random variable with mean and variance, respectively, of 0 and
2
converges to
the dirac-delta function f1(ST ) as 0.
9
Based on assumptions 1, 2, and 4 we can write down the following lemma:
Lemma 1 (Interest rate) The continuously compounded interest rate is given by:
r =
1
T
lnE
C
T
C
0
b
| F
0
= ln() +b
c

1
2
b
2
c

1
2
b
2
2
c
. (12)
Proofs for this and the subsequent formal results are available upon request. Lemma 1 ex-
presses the interest rate as a function of preference-based parameters. This identity will be useful
to simplify the stock-specic pricing kernel.
Option prices in our equilibrium framework are expectations with respect to a bivariate dis-
tribution of consumption and stock value. The goal of the next lemma is to reduce the dimen-
sionality of this problem by making option prices as an expectation with respect to the univariate
distribution of the individual stock. First, we dene two -subalgebras of F
t
. The subalgebra
F
st
(
s,
; = 0, 1, ..., t) is the -algebra generated by the stock price process. The subalgebra
F
ct
(
c,
; = 0, 1, ..., t) is the -algebra generated by the consumption process. The -algebra
F
t
is the direct product of the -algebras F
st
and F
ct
, i.e. F
t
= F
st
F
ct
. Then F
sT
contains
all the information about the shock to the stock price up to the expiration date of the option
T. The next lemma obtains the stock-specic pricing kernel by conditioning the pricing kernel on
the stock. The stock-specic pricing kernel will depend on preference parameters, parameters of
the consumption process, and parameters of the stock price. The stock-specic pricing kernel is
a function of the random stock price, but does not depend on random consumption. Hence, the
stock-specic pricing kernel is a function of this individual stock.
Lemma 2 (Stock-specic pricing kernel) The pricing kernel
0,T
(C
0,T
) conditional on
F
0
F
sT
is given by:
0,T
(S
0,T
) = E
C
T
C
0
b
| F
0
F
sT
(13)
10
= exp
bR
c
T
t=1
2
s,t
1/2
ln(S
0
) +
T
t=1
s,t

1
2
T
t=1
2
s,t
ln(S
T
)
1
2
b
2
R
2
2
c
T rT
.
where R is the correlation between the normal variates underlying consumption and the stock price.
The stock-specic pricing kernel (13) is positive and has a lognormal distribution:
0,T
(S
0,T
)
rT
1
2
b
2
R
2
2
c
T, b
2
R
2
2
c
T
, (14)
implying that there are no arbitrage opportunities between the individual stock and derivatives
written on this stock. This stock-specic pricing kernel can only be used to discount that individual
stock and derivatives written on that individual stock. The next section will use this stock-specic
pricing kernel as a stochastic discount factor to price call and put options. Note that there are as
many stock-specic pricing kernels in the economy as the number of individual stocks.
3 Preference-dependent pricing models
This section investigates the pricing of European call and put stock options that mature at date
T and have a strike price K. The prices of European call and put options, considering assumption
1, are given by the following formulae:
P
c
= E
C
T
C
0
(S
T
K)
+
| F
0
, (15)
P
p
= E
C
T
C
0
(K S
T
)
+
| F
0
. (16)
The next lemma uses the stock price process given by assumption 3 and the stock-specic
pricing kernel given by lemma 2 to derive closed-form solutions for the prices of the options.
Lemma 3 (Preference-dependent option prices) The prices of European call and put
options with a strike price K and a maturity date T are given by the following formulae:
P
c
= S
0
G(F
0
)N(d
1
)
T
t=1
(1
t
) Ke
rT
N(d
2
), (17)
P
p
=
1
T
t=1
(1
t
)
Ke
rT
+
T
t=1
(1
t
) Ke
rT
N(d
2
) S
0
G(F
0
)N(d
1
), (18)
11
where:
d
1
=
ln
S
0
Q(F
0
)
K
T
t=1
2
s,t
T
t=1
2
s,t
1/2
,
d
2
= d
1
t=1
2
s,t
1/2
,
G(F
0
) = exp
bR
c
t=1
2
s,t
1/2
+
T
t=1
s,t
rT +
T
t=1
ln(1
t
)
,
Q(F
0
) = exp
bR
c
t=1
2
s,t
1/2
+
T
t=1
s,t

1
2
T
t=1
2
s,t
,
and N(.) is the cumulative distribution function of a standard normal random variable.
Equations (17) and (18) are not preference-free option pricing equations since they depend
on the preference parameter b, the parameter of the consumption process
c
, and the correlation
between the normal variates underlying consumption and the stock price R. The next lemma gives
the equilibrium relation that supports the option prices given by equations (17) and (18). The result
is obtained using the call-put parity. This parity holds since there are no arbitrage opportunities
in the economy.
Lemma 4 (Underlying equilibriumrelationship) The underlying equilibrium of the econ-
omy is given by:
rT
T
t=1
ln(1
t
) =
T
t=1
s,t
bR
c
t=1
2
s,t
1/2
. (19)
This underlying equilibrium relation holds for the stock. The next section will use this un-
derlying equilibrium relation in the price of the options to eliminate preference-based parameters
from option prices and to derive preference-free option prices.
4 Preference-free option prices
This section derives preference-free closed-form solutions for the pricing of European call and
put options written on individual stocks. The more general result of this section, which is presented
12
in the next theorem, assumes that the volatility of the logarithmof stock returns and the probability
of bankruptcy follow nonstationary processes. Then we state two important special cases of this
theorem as corollaries. The rst corollary assumes that the volatility of the logarithm of stock
returns follows a stationary process, but that the probability of bankruptcy follows a nonstationary
process. The second corollary assumes that the volatility of the logarithm of stock returns and the
probability of bankruptcy followstationary processes. This model is useful, for example, when one is
interested in obtaining a single implied volatilityand a single implied probability of bankruptcy from
stock and stock option market prices. The preference-free option pricing equations are obtained
when we use the underlying equilibrium given by equation (19) in the preference-dependent option
pricing equations (17) and (18) to eliminate preference-parameters from these valuation equations.
Theorem (Option prices with nonstationary bankruptcy probability and nonsta-
tionary volatility) The prices of European call and put options with a strike price K and a
maturity date T are given by the following formulae:
P
c
= S
0
N(d
1
)
T
t=1
(1
t
) Ke
rT
N(d
2
), (20)
P
p
=
1
T
t=1
(1
t
)
Ke
rT
+
T
t=1
(1
t
) Ke
rT
N(d
2
) S
0
N(d
1
), (21)
where:
d
1
=
ln
S
0
K
+rT +
1
2
T
t=1
2
t

1
2
T
t=1
ln(1
t
)
T
t=1
2
t
+
T
t=1
ln(1
t
)
1/2
,
d
2
= d
1
t=1
2
t
+
T
t=1
ln(1
t
)
1/2
,
N(.) is the cumulative distribution function of a standard normal random variable, and
t
is the
volatility of the logarithm of stock returns at date t.
The theorem provides the more fundamental and general results presented in this paper.
Pricing equations (20) and (21) do not depend on preference parameters. They depend on the
current stock price S
0
, the strike price K, the interest rate r, the time-to-maturity of the option T,
13
the probability of bankruptcy 1
T
t=1
(1
t
) and the volatility of the logarithm of stock returns
t
. Note that neither the location parameter of the stock
s,t
nor the scale parameter of the stock
s,t
aect option prices.
The preference-free delta-lognormal distribution implicit in option prices (20) and (21) can be
written as:
S
T

1
T
t=1
(1
t
) , ln(S
0
) +rT
1
2
T
t=1
2
t

3
2
T
t=1
ln(1
t
) ,
T
t=1
2
t
+
T
t=1
ln(1
t
)
.
(22)
It is easily veried that the rst four moments of stock returns, considering the distribution
given by formula (22), are given by:
E
S
T
S
0
| F
0
= e
rT
, (23)
V ar
S
T
S
0
| F
0
= e
2rT
(
r
1) , (24)
Ske
S
T
S
0
| F
0
=

3
r
3
r
+ 2
(
r
1)
3/2
, (25)
Kur
S
T
S
0
| F
0
=

6
r
3
4
3
r
+ 6
r
3
(
r
1)
2
, (26)
where:
=
T
t=1
(1
t
),
r
= exp
t=1
2
t
.
The next corollary incorporates a nonstationary bankruptcy probability process in the Black-
Scholes (1973) valuation equations.
Corollary 1 (Call and put option prices with nonstationary bankruptcy probability
and stationary volatility) The prices of European call and put options with a strike price K and
a maturity date T are given by the following formulae:
P
c
= S
0
N(d
1
)
T
t=1
(1
t
) Ke
rT
N(d
2
), (27)
14
P
p
=
1
T
t=1
(1
t
)
Ke
rT
+
T
t=1
(1
t
) Ke
rT
N(d
2
) S
0
N(d
1
), (28)
where:
d
1
=
ln
S
0
K
r +
1
2
T
1
2
T
t=1
ln(1
t
)
2
T +
T
t=1
ln(1
t
)
1/2
,
d
2
= d
1
2
T +
T
t=1
ln(1
t
)
1/2
,
N(.) is the cumulative distribution function of a standard normal random variable, and is the
volatility of the logarithm of stock returns.
Corollary 1 shows that option prices depend on the current stock price, the strike price, the
interest rate, the time-to-maturity of the option, the probability of bankruptcy, and the volatility
of the logarithm of stock returns. They are independent of the location parameter and the scale
parameter of the stock. The preference-free delta-lognormal distribution implicit in option prices
(27) and (28) is given by:
S
T

1
T
t=1
(1
t
) , ln(S
0
) +rT
1
2
2
T
3
2
T
t=1
ln(1
t
) ,
2
T +
T
t=1
ln(1
t
)
. (29)
The rst four moments of S
T
/S
0
implicit in the option valuation equations (27) and (28) are
still given by equations (23), (24), (25), and (26), but now

and
r
are given by:
=
T
t=1
(1
t
),
r
= exp
2
T
.
Equations (23) and (24) do not depend on the probability of bankruptcy. This implies that
the risk-neutral lognormal implicit in the Black-Scholes valuation equations and the risk-neutral
delta-lognormal implicit in the option pricing equations (27) and (28) have identical mean (23) and
variance (24). This provides intuition to the fact that is the well known volatility parameter or
standard deviation of the logarithm of stock returns used in the Black-Scholes model. The scale
parameter of the stock was substituted in equilibrium by the stock volatility.
15
The next corollary simplies the option pricing problem. The closed-form solutions for the
pricing of options will depend only on observables, a single volatility parameter, and a single
bankruptcy probability parameter.
Corollary 2 (Call and put option prices with stationary bankruptcy probability
and stationary volatility) The prices of European call and put options with a strike price K and
a maturity date T are given by the following formulae:
P
c
= S
0
N(d
1
) (1 )
T
Ke
rT
N(d
2
), (30)
P
p
=
1 (1 )
T
Ke
rT
+ (1 )
T
Ke
rT
N(d
2
) S
0
N(d
1
), (31)
where:
d
1
=
ln
S
0
K
r +
1
2
T ln(1 )
T/2
[
2
+ln(1 )]
1/2
T
,
d
2
= d
1
2
+ln(1 )
1/2
T,
and N(.) is the cumulative distribution function of a standard normal random variable.
The preference-free delta-lognormal distribution implicit in option prices (30) and (31) is given
by:
S
T

1 (1 )
T
, ln(S
0
) +rT
1
2
2
T ln(1 )
3
2
T
,
2
T + ln(1 )
T
. (32)
The rst four moments of S
T
/S
0
implicit in the option valuation equations (30) and (31) are
still given by equations (23), (24), (25), and (26), but now

and
r
are given by:
= (1 )
T
,
r
= exp
2
T
.
When = 0 in equations (30) and (31) then the Black-Scholes (1973) model obtains. Equations
(30) and (31) also lead to Mertons (1976) ruin option pricing model. The ruin option pricing model
of Merton (1976) assumes that the stock price follows a jumpdiusion process with a jump size of
16
-100 percent when the jump occurs:
dS = (
s
+ )Sdt +
s
SdW Sdq,
where dW is the actual standard Gauss-Wiener process, dq the actual Poisson process with Prob(dq =
1) = dt, and is the mean number of jumps per unit of time. Our scale parameter
2
s
in Mer-
tons words is the instantaneous variance of the return, conditional on the no occurrence of jumps.
Mertons ruin option pricing model depends on
s
and rather than on and as in Corollary 2.
We obtain Mertons model from Corollary 2 in two steps. First, we have
2
s
=
2
+ ln(1 ). We
substitute this equation into d
1
and d
2
of Corollary 2, and rewrite:
d
1
=
ln
S
0
K
r ln(1 ) +
1
2
2
s
T
,
d
2
= d
1

s
T.
Now dene = ln(1 ) or (1 )
T
= e
T
. Substituting this relation into d
1
, d
2
, (30),
and (31) yields the Mertons ruin option pricing model:
P
c
= S
0
N(d
1
) Ke
(r+)T
N(d
2
),
P
p
=
1 e
T
Ke
rT
+Ke
(r+)T
N(d
2
) S
0
N(d
1
),
where:
d
1
=
ln
S
0
K
r + +
1
2
2
s
T
,
d
2
= d
1

s
T,
which depends on
s
and rather than on and of Corollary 2. While in Corollary 2 the
probability that the stock price goes to zero is , in Mertons ruin option pricing model the prob-
ability that the stock price goes to zero is dt. Hence our Corollary 2 is equivalent to Mertons
(1976) ruin option pricing model with a dierent interpretation of parameters. An inspection of
the formulas shows that while Mertons model allows one to recover the mean number of jumps per
17
unit of time from option prices, our model permits us to recover the probability of bankruptcy
implicit in option market prices. However, it seems unlikely that one could recover the probability
of bankruptcy from market prices using Mertons model without the relation that we establish in
this paper between and , = ln(1 ). In the next section, equations (30) and (31) are
going to be inverted to yield simultaneously the bankruptcy probability and the volatility as
functions of the other variables. The results are the implied bankruptcy probability and implied
volatility by option market prices.
10
5 Empirical testing of the model
5.1 Sample selection and data sources
To empirically test the model, we use two dierent data sets. First, we select rms where
stockholders face substantial bankruptcy risk. One of our main empirical objectives is to analyze
rms that were inuenced by the subprime mortgage crisis. To accomplish this for our second
data set, we analyze all nancial rms, selected building construction rms and business services
companies that have traded stock options. This makes it possible to examine the global impact of
the subprime crisis from a bankruptcy perspective.
To construct the rst sample, we investigate the largest U.S. rms that led for Chapter 11
bankruptcy protection and that have traded stock options during the period January 1998 through
December 2006. Information on the largest bankruptcies is obtained from the Bankruptcy Data
Division of New Generation Research, a provider of bankruptcy information on U.S. public and
private rms. We include all bankruptcies during this time period for rms with total assets greater
than one billion dollars and also include the top 15 to 20 largest bankruptcies in each year, even if
total assets are less than one billion dollars. This allows us to test the model on several bankruptcies
10
This can be implemented using, for example, a Newton-Raphson algorithm.
18
in each year of the sample period. Stock option data is obtained from Option Metrics, a market
vendor of option data. Of the 299 largest U.S. publicly-held rms that led Chapter 11 bankruptcy
protection over the sample period, we nd that stock options were actively traded on 109 of these
rms. Table 1 provides a list of these distressed rms together with the Chapter 11 ling date and
other important information which is discussed in the following subsections.
The second universe consists of all nancial rms that have options traded with prices reported
between January 1, 2007 and May 31, 2008. OptionMetrics has option and stock price information
on 145 companies. Among them, 129 are US based and 16 are foreign based. These are categorized
into the following 12 industry groups: Money Center Banks; Regional - Northeast Banks; Regional -
Mid-Atlantic Banks; Regional - Southeast Banks; Regional - Midwest Banks; Regional - Southwest
Banks; Regional - Pacic Banks; Foreign Money Center Banks; Foreign Regional Banks; Savings &
Loans; and Investment Brokerage - National; Investment Brokerage - Regional and Credit Services.
As part of this sample, we also select various rms in the building construction and business
services industries impacted by the subprime mortgage crisis to investigate the impact on selected
nonnancial rms. Options data for these rms was also obtained from Option Metrics.
5.2 Estimating the implied probability of bankruptcy
The probability of bankruptcy is estimated from Equations 30 and 31. The pricing equations
are inverted to yield implied values for the volatility and the bankruptcy probability. We estimate
values for these parameters by minimizing the sum of squared errors for each rm on each day.
We restrict our analysis to options with maturities between two weeks and six months and exclude
options that are far out-of-the-money. Risk-free rates are obtained from Option Metrics. The
rates are calculated using the continuously compounded zero-coupon interest rate derived from
LIBOR rates and CME Eurodollar futures. Where applicable, we subtract the present value of
dividends from the stock prices. Many of the distressed rms have suspended dividends by the
19
time of our analysis. The optimization procedure restricts volatility to non-negative values and the
default probability between zero and one. In several cases we identied reported option prices that
allowed arbitrage. We eliminated these prices from our analysis. However, for some rms during
very turbulent periods the optimization procedure could not converge (for example Bear Stearns
after March 12, 2008). If the optimization does not converge on a given date, that observation is
dropped. It is also possible in such days that the optimization procedure produces either zero or
one as an optimal result. If the estimate is zero, we report the average default probability of the
last ve days on that particular day. If the estimate is one, we keep it in our analysis. Note, that
this estimate is an expected value, so default probability of one should not be interpreted as an
imminent bankruptcy but as an extreme increase in the potential future troubles for that rm.
Estimates for the implied probability of bankruptcy are statistically signicant at the 5 percent
condence level.
5.3 Analysis of rms that have led for Chapter 11 bankruptcy protection
Table 1 presents the results for the implied probability of bankruptcy (delta) estimated for the
sample of 109 distressed rms. The mean delta is estimated as the average value for the most
recent six days in which data was available, the estimate was statistically signicant, and in which
the optimization procedure converges. Using the average delta over six trading days provides a
better estimate than using the estimate for one day. For example, it is not uncommon for deltas to
change by several percentage points daily when examining this group of distressed rms. The table
also lists the last date for which the bankruptcy probability can be estimated, the number of days
prior to bankruptcy ling that the probability is estimated, the senior long-term debt rating, and
the rms total assets for the year preceding the bankruptcy ling. The senior long-term debt rating
is based on Standard and Poors (S&P) Long-Term Senior Issuer Credit (or Moodys if S&P is not
available) and is obtained from Bloomberg on the exact date in which the last delta is estimated.
20
Debt ratings were available for 74 of the rms through Bloomberg. For the remaining 35 rms,
debt ratings were obtained for 18 of the companies through Compustat for the month in which the
last delta is estimated. Debt ratings were not available for the remaining 17 rms.
The mean delta is 24.5 percent for the group. The highest probability of bankruptcy is esti-
mated for Mariner Post-Acute (69.5 percent) and the lowest probability of bankruptcy is estimated
for Covanta Energy Corporation (1.5 percent). Interestingly, the delta for Mariner Post-Acute is
estimated 325 days prior to bankruptcy ling. At the time, the S&P credit rating was B+ which
indicates a greater vulnerability to default but currently has the capacity to meet interest pay-
ments and principal repayments. Given the high delta of 69.5 percent, this implies that the model
is useful in assessing the high probability of bankruptcy long before the Chapter 11 petition is
actually led. The model is also useful to gauge rm risk in which debt ratings are unavailable.
For example, for Motient Corporation, the delta is 66.4 percent 291 days before bankruptcy and
debt ratings are not listed for this company.
Table 2 shows the delta calculated for distressed rms sorted according to industry group and
year of bankruptcy ling. The largest number of bankruptcies (32) for sample rms occurred in
2001 and the fewest bankruptcies (3) were in 2006. The mean deltas for these years are 23.5 and
25.2 percent, respectively. The largest yearly mean delta of 32.9 percent occurs in 2000 and the
lowest of 21.7 percent occurs in 2003. For industry groups with more than one rm, the highest
mean delta is 32.9 for Transportation by Air (SICs 4500-4599, 7 rms) and the lowest is 14.2 percent
for Electric, Gas and Sanitary Services (SICs 4900-4999, 5 rms). Most bankruptcies (26 rms)
occurred in the Communications Industry (SICs 4800-4899) with a mean delta of 25.4 percent. On
the whole, it is clear that the results are not driven by one particular industry or bankruptcy year.
It is useful to compare the model for a sample of healthy rms. For this reason, we choose rms
in the Standard and Poors 500 (S&P500). All rms in the S&P500 are selected on which options
are actively traded during the period June through July 2006. We calculate mean deltas for each of
21
these 362 rms during this time frame. Panel A of Table 3 summarizes the minimum, maximum,
quartiles, means, standard deviations, and ranges for the probability of bankruptcy for the two
sample groups: distressed rms and S&P500 rms. As shown, the mean deltas (maximum deltas)
are 24.49 (69.46) and 1.92 (8.19) percent for distressed rms and S&P500 rms, respectively. Panel
B presents univariate tests of dierences in mean and median values for the deltas. The t-statistic
provides a test of the null hypothesis that the mean values of the probability of bankruptcy do
not dier between the two groups. The Wilcoxon sign-rank Z-statistic provides a test of the null
hypothesis that the median values do not dier. As shown in Panel B, the hypothesis of equal
implied probabilities of bankruptcy is rejected at the one percent signicance level as both the
mean and median values are signicantly higher for our sample of distressed rms.
In order to determine how our implied probability of bankruptcy compares with other proxies
for rm risk, we analyze the relation between delta and other measures such as the S&P debt rating,
the S&P common stock rating, and the Altman z-scores. The S&P common stock rating is obtained
from Compustat for the same month in which the last delta was estimated. Z-scores are obtained
from Compustat and are for the most recent year prior to bankruptcy ling for distressed rms
(or the closest year available) and for year-end 2005 for S&P500 rms. The z-score is an ordinal
measure and has no direct probabilistic interpretation. Likewise, none of the other measures provide
a direct probabilistic interpretation of bankruptcy or default. A key innovation of our model is that
we can get a direct sense of the risk of the company by looking at the bankruptcy probability. For
example, for Trans World Airlines (TWA), we can make the following statement: As of June 28,
2000, we estimated that there is an implied probability of probability of 61.1 percent that the rm
will go bankrupt within the next six months.
It is interesting to note that approximately seven months later, on January 10, 2001, TWA
led Chapter 11.
Table 4 reports these results. Panel A compares the mean delta for distressed rms versus
22
S&P500 rms sorted according to the debt rating. As shown, the lowest delta is obtained for the
rms with the highest quality debt rating for both groups and vice versa. With the exception
of distressed rms rated B, the delta increases monotonically consistent with the higher risk debt
ratings for both groups. The S&P historical global average one-year default rate is also listed for
comparison purposes. Note that the global average default rate for rms rated CCC and below is
similar to the delta estimated from our distressed rm sample (28.83 percent for S&P verses 27.79
and 30.54 percent for our distressed rms). It is important to note that these are average default
rates and that during periods of economic weakness, defaults and downgrades may be higher.
Panel B lists mean values for delta, the z-score, S&P debt rating, and S&P common stock
rating for the sample of distressed rms. Firms are grouped into four quartiles based on the delta.
Only rms in which the delta is estimated within one year of Chapter 11 ling are included. Z-
scores are not included in this panel if the value is not obtained within one year of the bankruptcy
ling date. It appears that neither the S&P debt rating nor the S&P equity distinguishes as well
as the delta and z-score for distressed rms. While there is not an overall trend for the relation
between size and probability of bankruptcy, the quartile for the highest delta has the lowest mean
rm size.
To examine whether an increase of the probability of bankruptcy precedes the debt rating
change for our sample rms, we conduct additional analysis and present these results in Panel C.
Analysis is restricted to rms with deltas greater than 14 percent and whose credit rating is available
through Bloomberg. We nd that delta increases implying a high probability of bankruptcy can
lead the debt rating change by a period of up to six months. Interestingly, the delta leads the debt
rating change by the longest period (two to six months) for sample rms with ratings of BB or
higher.
Figure 1 illustrates the delta for one of our sample rms, Dana Corporation, over the period
January 3, 2005 up until ten days before Chapter 11 bankruptcy was led. On January 3, 2005,
23
the delta was ve percent and by February 22, 2006, it had increased to 30 percent. On October
9, 2005, Danas management and Audit Committee determined, as a result of ongoing internal
investigations, that the company had not properly accounted for certain items during 2004 and
the rst and second quarters of 2005, and concluded that Danas nancial statements for those
periods should no longer be relied upon and should be restated. On October 10, 2005, Dana issued
a news release reporting these items and also reported the write-o of its U.S. deferred tax assets.
Over these two days, the delta increased to 29 percent. Clearly, the model captures the increased
bankruptcy probability of the rm over time.
Perhaps one of the most famous unexpected bankruptcies in recent times is the December 2,
2001 bankruptcy of Enron. Figure 2 illustrates the delta for Enron over the period January 1999
through December 2, 2001. As shown, the delta value is estimated at 14.2 percent on October 15th,
the day before Enron announced adjustments to earnings and equity reductions. By mid-November,
the implied delta was over 39 percent which demonstrates the models usefulness in capturing the
increased bankruptcy risk of a rm, even a rm subject to fraud.
5.4 Analysis of the subprime mortgage crisis and its replications around the
world
An important and highly useful application of the model is to analyze the impact of current events
as they unfold. To do this, we conduct a global analysis of rms impacted by the subprime mortgage
crisis. Because our model of risk uses contemporaneous data and does not rely on stale accounting
information, it provides additional information not available by most other models.
To test if the model captures important forward looking information about potential trouble
with rms, we investigate both global nancial rms and nonnancial rms (e.g., U.S. building
construction and business services rms) impacted by the subprime crisis. One of our objectives is
to identify how the subprime mortgage crises propagated around the world: from the United States
24
regional and center banks to foreign based center and regional banks. Our analysis illustrates two
primary channels for international transmission of the subprime crisis: common shocks (a con-
current impact such as experienced by money center banks globally) and spillover or contagion
eects (a lagged impact such as experienced by the building construction, credit services and re-
gional banking sectors, which our results show as of May 2008 is still unfolding for regional banks
both in the U.S. and globally).
11
Before discussing our results for the universe of nancial institutions analyzed, we rst look
at the building construction and business services industries. These industries have experienced
the spillover eect from the subprime crisis due to real sector demand declines and economic
slowdown. Table 5 and Figure 3 provide these results. Table 5 lists the delta on January 3, 2007
and the maximum delta (including the date for this value) for the 9 rms analyzed. The average
delta on January 3, 2007 is 2.74 percent whereas the average maximum delta is 22.30 percent.
The dierence in means is statistically signicant at the one percent level. The highest maximum
delta of 53.67 percent is obtained for PMI Group, a mortgage insurer, on March 19, 2008. A brief
explanation as to how each rm is impacted by the subprime crisis is also provided in the table.
While not included in Table 5 results, additional analysis shows that our model anticipates increases
in bankruptcy risk when debt ratings remain unchanged for this group of rms.
Figure 3 plots selected analysis from Table 5. Results are illustrated over the period January 3
through May 31, 2008. Estimates are daily averages of the delta for building construction (primarily
home builders). As shown, mean deltas are less than two percent at the beginning of the year and
remain less than ve percent through mid-March. During this period, concern over the subprime
mortgage sector was at a lower level and had not reached the crisis levels of late summer. By late
August 2007, the delta for the home building industry increases dramatically reaching 15 percent
11
See Brown and Davis (2008) and Mason (2008) for additional discussion on the global impact and implications
of the subprime crisis.
25
and higher, capturing the increased risk of bankruptcy in this market sector. Since August 2007,
the mean deltas have remained steadily high.
Next, we analyze the nancial interlinkages of banking rms around the world. The results
demonstrate both the micro and macro aspects of these interlinkages for the subprime crisis globally.
Table 6 provides descriptive statistics for the entire nancial universe we study and for dierent
industry groups. For the whole universe the average bankruptcy probability is 3.71 percent with
a maximum value of 9.68 percent on May 23, 2008. National and regional brokerages as well as
credit services rms have averages higher than 5 percent. The range of the maximum values for
is 6.93 percent(Regional northeast banks) to 32.81 percent(Regional midatlantic banks). Based
on the average (median) bankruptcy probability, brokerage houses, savings and loans and the
credit services rms are the most impacted by the subprime crisis. This results are consistent
with the observed empirical evidence - Bear Sterns, Moodys, Washington Mutual - all fall in the
above categories. Interestingly, the highest average default probability is observed for the regional
midatlantic banks. Specically, South Financial Group (TSFG) has a dramatic increase in the
default probability in May 2008 and at the same time, has experienced a large drop in stock price
from $20 per share to $3 per share.
Figure 4 shows the plot of the bankruptcy probability for all 145 nancial rms. Note that
there is an upward trend for the period January 2007 to May 2008. Around the Bear Stearns crisis
(March 17, 2008) one can observe a spike in the average default probability (from 6 to 9 percent).
Figure 5 plots the average bankruptcy probability for the US money center banks and foreign
money center banks. Panels A and B of Table 7 shows descriptive statistics for the individual rms
from that category. It is clear that the foreign money center banks reacted simultaneously with the
US money center banks around the Bear Sterns crisis. There was no delay in the increase of the
average default probability. This illustrates that nancial markets around the world have become
fully integrated and information gets disseminated very fast.
26
Average bankruptcy probabilities for the US regional banks are graphed in Figures 6 and
average bankruptcy probability for regional banks and foreign money center banks are graphed in
Figure 7. Table 8 shows descriptive statistics for the individual rms in the foreign regional banks
category. In these two categories, note that there is a delay in the response of the bankruptcy
probability. Their default probability has recently picked up. It will be important to observe for
how long this trend will continue.
The average bankruptcy probabilities for the US national and regional brokerage rms are
illustrated in Figure 8. Panels A and B of Table 9 provide the descriptive statistics for the individual
rms from these categories, respectively. Similar to the foreign rms category, the increase in the
default probability for the US regional brokers occurred with some delay relative to the increase
in the US national brokers. These results illustrate the spillover or contagion bankruptcy risk
eects due to the integrated nature of global nancial markets.
Figure 9 plots the average bankruptcy probability for the credit services rms. Table 10 shows
descriptive statistics for the individual rms from that category. On August 15, 2007, Represen-
tative Barney Frank announced plans to hold hearings in the House Financial Services Committee
investigating credit rating agencies role in the subprime mortgage crisis. Most likely in reaction to
this news, the implied probability of bankruptcy for the credit services rms increased dramatically
after that announcement. On May 19, 2008, Moodys delta had increased to a maximum level of
28.71 percent. These results further highlight the spillover eects of the subprime crisis into the
credit services industry.
Overall, the evidence in this section illustrates an important feature of our model: to analyze
crisis situations as they evolve and to gauge bankruptcy risk using a forward-looking measure
based on data from the option markets. We highlight the micro and macro aspects of international
nancial integration due to the subprime crisis.
In summary, the empirical results strongly support the model. We believe this model makes
27
important contributions to the literature and can be applied in a number of crucial areas of corporate
nance, including bankruptcy liquidation and reorganization. Furthermore, the model has potential
applications in other vital areas of nance including capital structure, executive compensation, and
nancial markets. For example, Bartram, Brown, and Hund (2005) obtain implied bankruptcy
probabilities using our model to study the event of a systemic failure of the global banking system.
6 Conclusions
Bankruptcy risk is of great concern to companies and businesses operating in all sectors of
nancial markets globally. Various tools and techniques have been used to assess bankruptcy risk,
most of which rely on historical data. This paper presents a forward looking measure that uses
stock and option prices to obtain an implied probability of bankruptcy. We derive option pricing
equations that are similar to Mertons ruin model, and empirically test the model for rms that
have led for Chapter 11 and global banks that have been impacted by the subprime mortgage
crisis.
The empirical results presented strongly support the model and demonstrate that it is able to
distinguish healthy rms from distressed rms. Our bankruptcy probability estimates are generally
consistent with other measures of rm risk including z-scores, senior long-term debt ratings, and
common stock ratings. Furthermore, we nd that the increases in the bankruptcy probability can
lead debt ratings changes by a period of up to six months in selected analysis.
We also test the model on rms impacted by the subprime mortgage crisis and the results are
striking. The average default probability for the global nancial rms universe increases steadily
since January 2007. The biggest increase is observed for the credit services rms and investment
brokerage houses. It is interesting to note that foreign center banks default probabilities increase
simultaneously with the US center banks, which illustrates the common shock eect of global
nancial integration. However, there is an observed delay for the foreign regional banks and US
28
regional investment brokerage rms, which illustrates the spillover eect of the crisis. This evi-
dence suggests that the world nancial markets are highly integrated and information disseminates
very fast across the globe.
29
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31
32
Table 1
Implied Probability of Bankruptcy Estimated for Public Companies with Traded Options that Filed for
Chapter 11 Bankruptcy during January 1998 through December 2006
This table lists the largest public companies with traded stock options that filed for bankruptcy during January 1998
through December 2006. Chapter 11 filing date is the day that the firm filed for bankruptcy protection. The mean
implied probability of bankruptcy is the average value estimated over the last six days for which data was
available and for which the optimization procedure converges. Also provided are the last date for which the
bankruptcy probability could be estimated, the number of days prior to bankruptcy filing that the last bankruptcy
probability is estimated, and the S&P senior long-term debt rating. The implied probability of bankruptcy is
estimated using Equations 30 and 31. Total assets are listed for the most recent annual report prior to bankruptcy.
Company Chapter 11
Filing Date
(%) Last Date
Estimated
Days to
Ch.11
Debt
Rating
Total
Assets
(Million)
360Networks (USA) 6/28/2001 12.6 2/26/2001 122
B+
$5,596.0
aaiPharma 5/10/2005 30.8 3/4/2005 66 CCC $ 339.1
Able Laboratories 7/18/2005 5.5 7/21/2005 -3 . $ 104.3
Adelphia Business Solutions 3/27/2002 29.2 7/18/2001 249 BB- $1889.5
Adelphia Communications 6/25/2002 22.5 4/11/2002 74 B $21,499.5
Allegiance Telecom 5/14/2003 14.6 1/28/2002 466 B $1,441.2
APW Ltd 5/16/2002 10.2 10/25/2001 201 . $523.7
Arch Wireless 12/6/2001 9.9 11/9/2000 387 B $2,309.6
Armstrong World 12/6/2000 4.4 10/9/2000 57 A- $4,164.0
Atlas Air Worldwide Holdings 1/30/2004 18.6 11/15/2002 435 B- $2,084.8
Boston Chicken 10/5/1998 13.0 4/30/1998 155 CCC $2,005.0
Breed Technologies 9/2/1999 38.0 5/28/1999 94 B- $1,660.0
Burlington Industries 11/15/2001 28.6 3/2/2000 613 BB+ $1185.0
CHS Electronics 4/4/2000 11.1 6/4/1999 300 B- $3,572
Calpine Corporation 12/20/2005 12.8 9/19/2005 91 B- $27,216.1
Collins & Aikman Corporation 5/17/2005 10.7 2/7/2005 100 B+ $ 3,196.7
Comdisco 7/16/2001 10.3 4/2/2001 104 BBB $8754.0
Conseco 12/18/2002 13.0 5/28/2002 200 B $61,392.3
Covad Communications 8/15/2001 22.1 12/14/2000 241 B- $442.2
Covanta Energy Corporation 4/1/2002 1.5 12/19/2001 102 BBB $3185.8
Dana Corporation 3/3/2006 21.2 2/23/2006 10 B+ $ 9,047.0
Delphi Corporation 10/8/2005 12.2 9/2/2005 36 CCC+ $ 16,593.0
Delta Air Lines 9/14/2005 14.3 7/21/2005 53 CC $ 21,801.0
Encompass Services Corporation 11/19/2002 12.2 8/4/2000 825 BB $2401.3
Enron Corporation 12/3/2001 24.5 11/19/2001 14 BBB- $63,300.0
Exodus Communications 9/26/2001 8.5 6/1/2001 115 B $3,894.4
Federal-Mogul Corporation 10/1/2001 12.5 6/11/2001 110 B+ $10,150.0
FINOVA Group 3/7/2001 20.5 11/15/2000 112 . $14,050.0
Flag Telecom Holdings 4/12/2002 7.0 8/6/2001 246 BB- $3476.7
Fleming Companies 4/1/2003 22.1 3/6/2003 25 B- $3,654.7
Footstar 3/2/2004 24.0 12/26/2003 66 . $775.3
FPA Medical Management 7/19/1998 10.6 5/18/1998 61 B+ $831.0
Friede Goldman Halter 4/19/2001 13.0 3/13/2001 36 CCC+ $822.0
Fruit of the Loom 12/29/1999 19.8 11/17/1999 42 B- $2,289.0
FLYi 11/7/2005 45.7 2/23/2005 254 CC $866.0
Genesis Health Ventures 6/22/2000 61.2 11/29/1999 203 B $2,430.0
Genuity 11/27/2002 33.4 7/25/2001 482 BBB+ $2994.5
Global Crossing Ltd. 1/28/2002 16.2 7/23/2001 185 BB+ $30,185.0
Global TeleSystems 11/14/2001 21.7 1/18/2001 296 CCC+ $2,833.8
Harnischfeger Industries 6/7/1999 15.6 5/28/1999 9 . $2,876.0
Heilig-Meyers 6/16/2000 55.0 5/4/2000 42 BB- $1,456.0
InaCom Corporation 6/16/2000 21.1 1/5/2000 161 BB- $1103.5
ICG Communications 11/14/2000 36.2 9/11/2000 63 B- $2,020.0
Integrated Health Services 2/2/2000 14.1 7/21/1999 191 B- $5,393.0
33
Interstate Bakeries Corporation 9/22/2004 23.9 9/20/2004 2 CCC+ $1,645.7
Iridium LLC/Capital Corporation 8/13/1999 34.8 7/29/1999 14 . $3,738.0
JumboSports 12/27/1998 67.5 11/5/1997 412 CCC $467.0
Kaiser Aluminum Corporation 2/12/2002 27.0 8/28/2000 524 . $3,364.3
LTV Corporation 12/29/2000 49.5 7/21/2000 158 BB- $6,101.0
Laidlaw 6/28/2001 4.8 11/30/1999 568 BBB $4,000.0
Leap Wireless International 4/13/2003 22.6 5/2/2002 341 B- $2,163.7
Lodgian 12/20/2001 36.7 7/28/2000 502 B+ $1164.0
Loewen Group International 6/1/1999 8.6 1/12/1999 139 BB $3,738.0
Loral Space & Communications 7/15/2003 24.3 1/28/2002 527 B $2,692.8
Loews Cineplex Entertainment 2/15/2001 40.3 4/6/2000 309 BB- $1677.6
Mariner Post-Acute 1/18/2000 69.5 2/23/1999 325 B+ $3,037.0
McLeodUSA 1/30/2002 10.3 12/27/2000 393 B+ $4,755.1
Metals USA 11/14/2001 10.9 1/25/2000 649 BB- $689.9
Metricom 7/2/2001 18.2 4/16/2001 76 CCC $1253.6
Mirant Corporation 7/14/2003 24.9 7/11/2003 3 CCC+ $19,415.0
Motient Corporation 1/10/2002 66.4 3/19/2001 291 . $209.6
National Steel 3/6/2002 10.5 5/22/2000 644 B+ $2307.6
Northwest Airlines 9/14/2005 20.9 9/2/2005 12 CCC+ $14,042.0
Northwestern Corporation 9/14/2003 15.5 4/8/2003 156 B $2,672.9
OCA 3/14/2006 18.1 5/2/2005 312 . $660.3
Owens Corning 10/5/2000 36.3 9/21/2000 14 BB- $6920.0
Pacific Gas & Electric 4/6/2001 15.1 4/6/2001 0 D $29,770.0
Paging Network 7/24/2000 67.2 3/2/2000 142 D $1422.6
Paragon Trade Brands 1/6/1998 1.7 12/16/1997 20 . $373.0
Peregrine Systems 9/22/2002 43.7 6/5/2002 107 . $2003.8
Petroleum Geo-Services ASA 7/29/2003 43.3 7/30/2002 359 BBB- $4,302.8
Pillowtex Corporation 11/14/2000 26.1 8/28/2000 76 CCC $1,683.0
Pinnacle Holdings 5/21/2002 14.0 8/9/2001 282 B- $1034.3
Polaroid Corporation 10/12/2001 23.9 6/15/2001 117 CCC+ $2043.0
PSINet 5/31/2001 16.7 10/23/2000 218 B- $4,492.3
Refco 10/17/2005 4.7 10/13/2005 4 B $33,333.2
Reliance Acceptance Corp. 2/9/1998 22.6 10/3/1997 126 . $553.0
Reliance Group Holdings 6/12/2001 53.8 4/3/2000 429 BBB- $12,598.1
Rhythm NetConnections 8/1/2001 12.0 9/29/2000 302 CCC+ $1056.3
RSL Communications 3/19/2001 46.5 9/22/2000 177 B- $1803.3
Safety-Kleen 6/9/2000 4.7 1/4/2000 155 D $4,367.0
Singer Company 9/12/1999 33.7 4/30/1999 132 CCC $1753.9
Solutia 12/17/2003 10.0 10/9/2003 68 B- $3,342.0
SpectraSite Holdings 11/15/2002 54.7 1/14/2002 301 B $2578.5
Spiegel 3/17/2003 10.3 10/30/2001 497 . $1,889.6
Sun Healthcare Group 10/14/1999 14.6 1/14/1999 270 B $2,468.0
Sunbeam Corporation 2/6/2001 53.4 8/25/2000 161 CCC+ $3132.3
Sunterra Corporation 5/31/2000 4.6 1/14/2000 137 BB- $1058.4
Teligent Communications 5/21/2001 4.1 10/4/2000 227 B- $1209.5
Touch America Holdings 6/19/2003 22.0 7/26/2002 323 . $3,059.5
Tower Automotive 2/2/2006 37.2 11/5/2004 447 B+ $2291.2
Trans World Airlines 1/10/2001 61.6 6/28/2000 192 CCC $2137.2
UAL Corporation 12/9/2002 40.0 11/25/2002 14 CCC $25,197.0
Ultimate Electronics 1/11/2005 34.8 2/11/2005 -30 . $336.2
United Pan-Europe Comm. N.V. 12/3/2002 16.1 6/4/2001 539 B+ $4931.0
U.S. Airways Group 9/12/2004 23.2 7/22/2004 50 B- $8349.0
U.S. Office Products Company 3/5/2001 52.8 2/4/2000 391 B $1745.7
Vencor 9/13/1999 15.4 10/15/1999 -32 . $1,718.0
Viatel 5/2/2001 27.0 1/12/2001 110 B- $2155.4
Warnaco Group 6/11/2001 18.3 2/15/2001 116 BB $2372.7
Webvan Group 7/13/2001 29.2 9/18/2000 295 . $1521.5
Westpoint Stevens 6/1/2003 29.3 7/17/2001 674 B $1,368.9
Williams Communications Group 4/22/2002 48.1 11/28/2001 144 B $5,992.0
34
Winn-Dixie Stores 2/21/2005 10.2 2/9/2005 12 B- $2,618.9
Winstar Communications 4/18/2001 15.7 3/14/2001 34 B $4,975.4
World Access 4/24/2001 12.8 1/30/2001 84 B $1629.8
WorldCom 7/21/2002 14.9 4/18/2002 93 BBB+ $103,900.0
W.R. Grace & Company 4/2/2001 14.5 1/5/2001 87 BB+ $2509.1
XO Communications 6/17/2002 6.7 10/18/2001 239 B- $7,930.5
Mean 24.5 203 B $6876.4

35
Table 2
Mean Implied Probability of Bankruptcy by Industry and Year

This table shows the implied probability of bankruptcy by industry and year for the sample of distressed firms.
The % of Firms column total may not sum exactly to 100% because of rounding.
SIC Industry Group
SIC
Code
1998 1999 2000 2001 2002 2003 2004 2005 2006 N %
Firms
Mean

Mining and Construction
1000-
1999
- - - - 1 1 - - - 2 1.8 27.7
Manufacturing
2000-
3999
1 3 4 10 2 3 2 2 2 30 27.5 22.7
Food and Kindred
Products
2000-
2099
- - - - - - 1 - - 1 0.9 23.9
Textile Mill Products;
Apparel and Other
2200-
2399
- 1 1 3 - 1 - 1 - 7 6.4 26.6
Paper, Printing, Chemicals
& Allied
2600-
2899
1 - - 1 - 1 1 1 - 5 4.6 15.3
Stone, Clay, etc Products;
Primary Metal Ind.
3200-
3399
- - 2 1 2 - - - - 5 4.6 26.8
Fab. Metal Prod; Ind. &
Comm. Mach & Comp
Eq; Other
3400-
3699
- 1 - 3 - - - - 1 5 4.6 30.0
Transportation Equipment
3700-
3799
- 1 - 1 - - - 1 1 4 3.7 23.1
Measuring,
Analyzing/Control Inst;
Misc. Manuf.

3800-
3999
- - 1 1 - 1 - - - 3 2.8 17.5
Transportation,
Communications, Electric,
Gas, and Sanitary Service
4000-
4999
- 1 3 12 13 5 1 4 - 39 35.8 24.8
Local and Suburban
Transit and Related
4100-
4199
- - - 1 - - - - - 1 0.9 4.8
Transportation by Air
4500-
4599
- - - 1 2 - 1 3 - 7 6.4 32.9
Communications
4800-
4899
- 1 2 9 11 3 - - - 26 23.9 25.4
Electric, Gas and Sanitary
Services

4900-
4999
- - 1 1 - 2 - 1 - 5 4.6 14.2
Wholesale Trade
5000-
5199
- - 1 1 1 1 - - - 4 3.7 17.0
Retail Trade
5200-
5999
2 1 1 1 - 1 1 2 - 9 8.3 32.4
Finance, Insurance, and
Real Estate
6000-
6999
1 1 1 2 2 - - 1 - 8 7.3 20.9
Services
7000-
8999
1 2 4 6 2 - - 1 1 17 15.6 25.8
Hotels, Rooming Houses,
Camps and Other
7000-
7099
- - 1 1 - - - - - 2 1.8 20.6
Personal and Business
Services
7200-
7399
- 1 - 4 2 - - - - 7 6.4 21.5
Motion Pictures
7800-
7899
- - - 1 - - - - - 1 0.9 40.3
Health Services
8000-
8099
1 1 3 - - - - - 1 6 5.5 31.2
Engineering, Accounting,
& Related Services

8700-
8799
- - - - - - - 1 - 1 0.9 20.2
Total Firms (N)
5 8 14 32 21 11 4 11 3 109
Percentage of Total Firms
4.6 7.3 12.8 29.4 19.3 10.1 3.7 10.1 2.8 100
Implied Probability of
Bankruptcy , %
23.1 22.6 32.9 23.5 23.7 21.7 22.4 23.5 25.2 24.5 24.5
36

Table 3
Estimated Probability of Bankruptcy

Panel A: Descriptive Statistics for Implied Probability of Bankruptcy
This panel contains the minimum, maximum, quartiles, means, standard deviations, and ranges for the implied
probability of bankruptcy for sample firms. The implied probability of bankruptcy is estimated over the period
1998 to 2006 for distressed firms and June through July 2006 for S&P 500 firms, respectively.

Distressed
Firms
S&P 500
Firms

Minimum 1.49 % 0.48 %
Quartile 1 12.64 % 1.20 %
Median 20.51 % 1.65 %
Quartile 3 33.67 % 2.45 %
Maximum 69.46 % 8.19 %
Mean 24.49 % 1.92 %
Standard deviation 16.38 % 1.09 %
Range 67.97 % 7.71 %
N 109 362

Panel B: Tests of Differences in Probability of Bankruptcy
This panel presents univariate tests of differences in mean and median values between distressed firms and S&P 500
firms for the probability of bankruptcy . The t-statistic provides a test of the null hypothesis that the mean values of
the probability of bankruptcy do not differ between the two groups. The Wilcoxon sign-rank Z-statistic provides a
test of the null hypothesis that the median values do not differ. Significance levels are indicated as follows: ***1%,
**5%, *10%.

Distressed Firms S&P 500
Firms
Mean
[Median]
Mean
[Median]
t-statistic
(p-value)
Wilcoxon
Sign rank
Z-statistic
(p-value)
24.49
[20.51]
1.92
[1.65]
14.37 ***
(<0.0001)
15.47 ***
(<0.0001)

37
Table 4
Comparison of Implied Probability of Bankruptcy with Other Measures of Firm Risk

Panel A: Comparison of Implied Probability of Bankruptcy with Debt Ratings
This panel compares the mean implied probability of bankruptcy () for sample firms versus S&P 500 firms sorted
according to the senior long-term debt credit rating. The for distressed firms is measured over the period described
in Table 1. The for S&P 500 firms is estimated over the period June through July 2006. The historical S&P global
average one-year default rate is also listed for comparison purposes.

Distressed Firms S&P 500 Firms S&P Long-Term
Senior Debt Rating
(or Moodys
Equivalent)
Mean N Mean N
S&P Global
Average One-
Year Default
Rate
a
AAA to AA -- -- 1.58 % 25 0.01 %
A 4.36 % 1 1.60 % 124 0.04 %
BBB 18.90 % 5 1.86 % 132 0.29 %
BB 25.06 % 12 2.84 % 33 1.20 %
B 22.04 % 35 3.15 % 7 5.71 %
CCC 27.79 % 16 -- -- 28.83 %
b
Below CCC 30.54 % 5 -- -- --
N 109 362

a
Source: S&P Quarterly Default Update & Rating Transitions, April 2005. Average default rate is for the period
1981 to 2004.
b
Value includes firms rated CCC and lower.

Panel B: Comparison of Implied Probability of Bankruptcy with Other Risk Measures for Distressed Firms

This panel lists mean values for the implied probability of bankruptcy and other measures of firm risk for the
sample of distressed firms. Firms are grouped into four quartiles based on the implied probability of bankruptcy .
Only firms in which the is estimated within one year of Chapter 11 filing are included. Z-scores are included if
available within one year of the bankruptcy filing date.

Mean Total Assets
($ Millions)
z-score S&P Senior LT
Debt Rating
a
S&P Equity
Rating
b
Quartile 1 8.51 % 6236.6 0.402 16.2 18.3
Quartile 2 16.07 % 12,634.5 0.051 17.7 19.2
Quartile 3 25.28 % 7526.6 -0.181 17.5 18.6
Quartile 4 48.71 % 4230.1 -0.304 17.8 19.6
N 89 89 39 72 46

a
The S&P senior long-term debt rating has been converted to the numerical code that Compustat uses, as follows:
2=AAA, 4=AA+, 5=AA, 6=AA, 7=A+, 8=A, 9=A-, 10=BBB+, 11=BBB, 12=BBB-, 13=BB+, 14=BB, 15=BB-,
16=B+, 17=B, 18=B-, 19=CCC, 20=CC, 21=C, 22=D.
b
The S&P equity rating obtained from Compustat follows a similar numerical scale. For example, 7=A+ (Highest),
16=B+ (Average0, 17=B (Below Average), 18=B- (Lower), 21=C (Lowest).

38
Panel C: Comparison of Implied Probability of Bankruptcy with Debt Ratings Changes
This panel reports the period in months (see column on right) that the implied probability of bankruptcy () increase
preceded the debt rating change for the sample of distressed firms. Sample firms are selected whose credit rating
was available through Bloomberg. The , mean debt rating, and days to Chapter 11 is measured over the period
described in Table 1. The debt ratings are converted to numerical code as described in Panel B.

Distressed Firms
N Mean Mean Debt
Rating
Mean Days
to Ch.11
Period
Precedes Debt
Rating Change

Firms with credit rating
BB or higher
8
31.17 % 12.8 223.5
Two to six
months
B or CCC
36
31.12 % 17.9 214.5
One to three
months
CC or lower
3
42.38 % 24.3 149.7
Less than one
month
All above firms 47 32.04 % 17.2 214.9 Up to six months

39

Table 5
Implied Probability of Bankruptcy () for Firms Impacted by the Subprime Mortgage Crisis
This table presents analysis on 9 construction and business services firms impacted by the subprime mortgage crisis.
Analysis is conducted over January 2007 through May 2008.

Company
(Industry)
on Jan.
3, 2007
Maximum
and Date
Wall Street Journal News (Date)
CarMax
(Retailer)
7.31%
17.63%
(1/3/08)
Cut its earnings estimate for fiscal 2008, blaming housing slump and subprime-
mortgage crisis for slowing auto sales. (Sept. 19, 2007)
Centex (Building
Construction)
2.27%
30.43%
(4/2/08)
The company took $1 billion in third-quarter charges from significant effects of the
mortgage-market disruptions. (Oct. 12, 2007)
FedEx
(Transportation)
1.58%
8.31%
(4/16/08)
Firm will cut earnings estimate, blaming slowing economy; says "freight business
has been impacted by the slowing economy, especially the housing market." (Sept.
20, 2007)
General Electric
(Conglomerate)
0.00%
5.44%
(4/14/08)
Expects a $300-$300 million loss related to its planned exit from the subprime
market, third time in as many quarters that GE's results will be affected by subprime
woes. (Sept. 18, 2007)
KB Home
(Building
Construction)
7.17%
24.61%
(3/24/08)
Year-over-year revenue dropped 32%. Oversupply of unsold new and resale homes
and downward pressure on new home values has worsened in many of our markets
as tighter lending standards and related factors suppress demand. (Sept. 27, 2007)
Lennar (Building
Construction)
3.2%
28.95%
(2/8/08)
Swung to loss, cut 35% of work force. (Aug. 6, 2007)
Lowe's (Retail
Trade)
2.66%
9.03%
(3/31/08)
Expects EPS at low end of an earlier forecast; blames a weaker housing market than
most predicted, a subprime credit situation that was deeper than most realized, and
deflation in lumber and plywood. (Sept. 26, 2007)
McGraw Hill
(Publishing,
Business
Services for
S&P Subsidiary)
0.50%
22.66%
(11/14/07)
Representative Barney Frank announces plans to hold hearings in the House
Financial Services Committee investigating credit rating agencies role in the
subprime mortgage crisis. (Aug. 15, 2007)
PMI Group
(Mortgage
Insurer)
0.00%
53.67%
(3/19/08)
Expects to report a third-quarter loss of about $1.05 a share. (Oct. 19, 2007)
Average 2.74% 22.30%

40

Table 6
Implied Probability of Bankruptcy () for All Financial Firms with Traded Stock Options

This table presents the average, median, and maximum implied probability of bankruptcy for all financial firm
groups over the period January 2007 through May 2008.

Average () Median () Max ()
Financial Universe 3.71% 3.95% 9.69%
Money Center Banks 2.18% 2.30% 13.33%
Regional - Northeast Banks 1.83% 1.12% 6.93%
Regional - Mid-Atlantic Banks 1.31% 0.25% 32.81%
Regional - Southeast Banks 1.80% 0.79% 11.00%
Regional - Midwest Banks 1.65% 1.13% 7.25%
Regional - Southwest Banks 1.40% 1.12% 10.23%
Regional - Pacific Banks 2.97% 1.72% 10.87%
Foreign Money Center Banks 2.34% 1.92% 9.60%
Foreign Regional Banks 3.56% 2.83% 10.54%
Savings & Loans 4.23% 4.37% 18.18%
Investment Brokerage - National 5.49% 5.95% 16.27%
Investment Brokerage - Regional 5.74% 5.55% 15.77%
Credit Services 5.60% 5.92% 15.87%

41

Table 7
Implied Probability of Bankruptcy () for All Money Center Banks

This table presents the average, median, maximum and date of the maximum implied probability of bankruptcy for
all money center banks over the period January 2007 through May 2008.

Pane A: Money Center Banks

Ticker Company Name Average () Median () Max () Date Max
obtained
BAC BANKAMERICA CORP 1.54% 0.10% 10.14% 3/17/2008
BK BANK OF NEW YORK MELLON
CORP
1.90% 0.00% 11.04% 11/16/2007
C CITIGROUP INC 2.04% 0.00% 20.45% 3/20/2008
FDC FIRST DATA CORP 4.42% 1.51% 100.00% 8/16/2007
JPM J P MORGAN CHASE & CO 3.20% 2.94% 17.68% 3/17/2008
KEY KEYCORP NEW 1.29% 0.00% 13.83% 3/18/2008
MEL MELLON BANK CORP 0.02% 0.00% 1.40% 6/22/2007
OFG ORIENTAL FINANCIAL GROUP 2.35% 0.00% 74.70% 10/15/2007
PNC PNC BANK CORP 1.37% 0.06% 8.57% 2/5/2008
RY ROYAL BK CDA MONTREAL
QUE
1.00% 0.00% 7.01% 3/6/2008
STI SUNTRUST BKS INC 1.32% 0.00% 11.76% 3/20/2008
TCB TCF FINL CORP 2.76% 0.50% 22.32% 2/1/2007
TD TORONTO DOMINION BK ONT 0.53% 0.00% 6.60% 1/14/2008
WB WACHOVIA CORP NEW 8.16% 0.79% 100.00% 9/25/2007
WFC WELLS FARGO & CO 0.82% 0.00% 14.33% 3/20/2008

Panel B: Foreign Money Center Banks

Ticker Company Name Country Average () Median () Max () Date Max
obtained
ABN ABN AMRO HLDG
NV
Netherlands 1.50% 0.01% 12.97% 3/26/2008
CS CREDIT SUISSE
GROUP
Switzerland 0.94% 0.00% 8.92% 1/8/2008
DB DEUTSCHE BANK
AG
Germany 1.31% 0.52% 9.17% 4/2/2008
IBN ICICI BK LTD India 2.84% 2.20% 12.74% 11/23/2007
ITU BANCO ITAU HLDG
FINANCIERA S
Brazil 2.98% 2.41% 11.73% 3/20/2008
MTU MITSUBISHI UFJ
FINL GROUP IN
Japan 2.94% 0.97% 28.20% 11/13/2007
UBB UNIBANCO-UNIAO
DE BANCOS BRA
Brazil 3.22% 2.91% 11.70% 2/21/2008
UBS UBS AG Switzerland 2.99% 1.34% 35.38% 3/20/2008

42

Table 8
Implied Probability of Bankruptcy () for All Foreign Regional Banks

all foreign regional banks over the period January 2007 through May 2008.

Ticker Company Name Country Average () Median () Max () Date
Max obtained
BBD BANCO
BRADESCO
Brazil 6.29% 0.17% 52.82% 5/27/2008
BBV BANCO BILBAO
VIZCAYA
ARGENTA
Spain 0.99% 0.00% 17.85% 1/19/2007
BPOP Banco Popular Puerto
Rico
1.63% 0.00% 11.07% 3/31/2008
CIB BANCOLOMBIA Colombia 1.60% 1.33% 9.24% 1/18/2007
FBP FIRST BANCORP Puerto
Rico
1.89% 0.00% 16.02% 3/15/2007
HDB HDFC BANK LTD India 4.09% 3.38% 11.82% 1/16/2008
KB KOOKMIN BK South
Korea
2.71% 2.46% 13.61% 9/17/2007
RGF R & G FINANCIAL
CORP
Puerto
Rico
9.26% 9.89% 15.96% 2/16/2007

43

Table 9
Implied Probability of Bankruptcy () for Brokerage Firms

all brokerage firms examined over the period January 2007 through May 2008.

Panel A: National Brokerage Firms

Ticker Company Name Average () Median () Max () Date Max obtained
AMTD TD AMERITRADE HLDG
CORP
8.88% 4.69% 53.58% 8/16/2007
BSC BEAR STEARNS COS INC 5.19% 3.78% 30.64% 3/12/2008
COWN COWEN GROUP INC 8.78% 1.27% 100.00% 3/7/2008
ETFC E TRADE FINANCIAL CORP 6.87% 3.96% 39.59% 3/20/2008
GS GOLDMAN SACHS GROUP
INC
4.19% 4.03% 15.88% 3/17/2008
IBKR INTERACTIVE BROKERS
GROUP IN
6.33% 0.00% 34.23% 5/1/2008
LEH LEHMAN BROS HLDGS INC 6.70% 5.70% 35.93% 3/27/2008
MER MERRILL LYNCH & CO INC 4.58% 3.43% 35.71% 3/19/2008
MS MORGAN STANLEY 9.35% 6.73% 100.00% 10/10/2007
NMR NOMURA HLDGS INC 1.65% 0.50% 18.68% 12/5/2007
OXPS OPTIONSXPRESS HLDGS
INC
3.04% 2.38% 17.57% 3/17/2008
SCHW SCHWAB CHARLES CORP
NEW
2.82% 2.09% 15.27% 3/18/2008
SEIC SEI CORP 3.65% 2.83% 25.90% 3/18/2008
TRAD TRADESTATION GROUP INC 4.86% 4.43% 17.12% 2/29/2008

Panel B: Regional Brokerage Firms

AGE EDWARDS AG INC 1.18% 1.51% 4.14% 9/28/2007
BLK BLACKROCK INC 2.29% 1.82% 11.08% 4/14/2008
FBR FRIEDMN BILLINGS RMSY 7.13% 1.38% 44.65% 5/27/2008
GFIG GFI GROUP INC 6.48% 5.92% 26.67% 3/18/2008
ITG INVESTMENT
TECHNOLOGY GP INC
3.79% 3.61% 13.61% 3/17/2008
JEF JEFFERIES GROUP INC 2.18% 0.74% 12.59% 4/7/2008
LAB LABRANCHE & CO INC 5.30% 0.86% 100.00% 10/23/2007
LM LEGG MASON INC 2.55% 1.43% 16.66% 5/22/2008
NITE KNIGHT CAPITAL GROUP
INC
5.01% 4.37% 13.22% 3/20/2008
RJF RAYMOND JAMES
FINANCIAL INC
3.22% 1.33% 30.25% 11/12/2007
SF STIFEL FINL CORP 12.90% 0.00% 100.00% 7/16/2007
SWS SOUTHWEST SECURITIES
GROUP
2.60% 0.00% 23.85% 5/12/2008
USO UNITED STATES OIL FUND
LP
24.85% 25.25% 100.00% 10/11/2007
WDR WADDELL & REED FINL
INC
0.86% 0.00% 18.02% 8/13/2007
44

Table 10
Implied Probability of Bankruptcy () for All Credit Services Firms

all credit services firms examined over the period January 2007 through May 2008.

AACC ASSET ACCEP CAP CORP 7.29% 5.05% 38.47% 7/17/2007
ACF AMERICREDIT CORP 11.41% 9.40% 67.90% 1/29/2008
ADS ALLIANCE DATA SYSTEMS
CORP
4.50% 2.85% 28.56% 1/24/2008
ADVNB ADVANTA CORP 1.54% 0.00% 21.41% 5/2/2008
AEA ADVANCE AMER CASH
ADVANCE CT
3.04% 0.69% 22.41% 4/15/2008
AXP AMERICAN EXPRESS CO 8.01% 5.48% 100.00% 10/12/2007
CCRT COMPUCREDIT CORP 12.00% 9.68% 52.67% 1/16/2008
CIT CIT GROUP INC 5.12% 1.36% 27.59% 4/16/2008
COF CAPITAL ONE FINL CORP 7.12% 5.72% 21.64% 3/17/2008
CSE CAPITALSOURCE INC 3.57% 0.00% 32.90% 4/9/2008
CSH CASH AMER INTL INC 4.01% 2.62% 18.51% 5/30/2008
EFX EQUIFAX INC 1.54% 0.14% 11.22% 1/8/2008
EZPW EZCORP INC 7.91% 7.72% 22.77% 2/20/2008
FCFS FIRST CASH FINL SVCS
INC
7.82% 0.98% 66.53% 3/18/2008
FMD FIRST MARBLEHEAD CORP 5.70% 3.54% 33.77% 3/3/2008
FNM FEDERAL NATL MTG ASSN 4.57% 1.64% 45.68% 3/18/2008
MCO MOODYS CORP 7.57% 6.67% 28.71% 5/19/2008
NNI NELNET INC 3.44% 1.95% 19.41% 5/2/2008
PHH PHH CORP 2.65% 1.42% 23.39% 2/6/2008
SFI STARWOOD FINANCIAL
INC
3.52% 0.00% 31.85% 4/10/2008
SLM SLM CORP 7.43% 6.53% 37.59% 3/24/2008
TAXI MEDALLION FINL CORP 0.75% 0.00% 11.62% 5/23/2008
WRLD WORLD ACCEP CORP DEL 8.21% 7.85% 18.34% 4/17/2008

45
Figure 1
Implied Probability of Bankruptcy for Dana Corporation
(Chapter 11 Bankruptcy filed 3/3/06)
0%
5%
10%
15%
20%
25%
30%
35%
1
/
3
/
2
0
0
5
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2
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1
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6
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/
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0
6
2
/
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3
/
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0
0
6
Date
P
r
o
b
a
b
i
l
i
t
y

o
f

B
a
n
k
r
u
p
t
c
y

(
D
e
l
t
a
)

46
Figure 2
Implied Probability of Bankruptcy for Enron
(Note: Enron filed Chapter 11 on December 2, 2001)
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
1
/
7
/
1
9
9
9
2
/
7
/
1
9
9
9
3
/
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/
1
9
9
9
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/
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9
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9
5
/
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/
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9
9
9
6
/
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/
1
9
9
9
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/
7
/
1
9
9
9
8
/
7
/
1
9
9
9
9
/
7
/
1
9
9
9
1
0
/
7
/
1
9
9
9
1
1
/
7
/
1
9
9
9
1
2
/
7
/
1
9
9
9
1
/
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/
2
0
0
0
2
/
7
/
2
0
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3
/
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/
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0
4
/
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5
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/
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/
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0
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/
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0
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/
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2
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0
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1
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/
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/
2
0
0
0
1
1
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7
/
2
0
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0
1
2
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/
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/
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0
1
Date
P
r
o
b
a
b
i
l
i
t
y

o
f

B
a
n
k
r
u
p
t
c
y

(
D
e
l
t
a
)
Implied Bankruptcy probability of 14.2% on October 15, 2001, the day before
Enron announces $544 Million after tax charge and $1.2 billion equity reduction.
November 19, 2001. Enron files its quarterly 10Q; also restated 1999 and
2000 net income retroactiverly. SEC requested information on LJM2.

47
Figure 3
Average Implied Probability of Bankruptcy for Building Construction Firms
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
1
/
3
/
2
0
0
7
2
/
2
/
2
0
0
7
3
/
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/
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3
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/
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/
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8
48
Figure 4
Average Implied Probability of Bankruptcy for Global Financial Firms with Traded Stock Options

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

49
Figure 5
Average Implied Probability of Bankruptcy for Global Money Center Banks
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008
Money Center Banks Foreign Money Center Banks

50

Figure 6
Average Implied Probability of Bankruptcy for All US Regional Banks

-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008
Regional - Northeast Banks Regional - Mid-Atlantic Banks Regional - Southeast Banks
Regional - Midwest Banks Regional - Southwest Banks Regional - Pacific Banks

51
Figure 7
Average Implied Probability of Bankruptcy for All Foreign Center Banks and Foreign Regional Banks

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008
Foreign Money Center Banks Foreign Regional Banks

52
Figure 8
Average Implied Probability of Bankruptcy for All National and Regional Brokerage Firms

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008
Investment Brokerage - National Investment Brokerage - Regional

53
Figure 9
Average Implied Probability of Bankruptcy for All Credit Services Firms
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
1/3/2007 4/13/2007 7/22/2007 10/30/2007 2/7/2008 5/17/2008

Implied Bankruptcy Prob - Merton Based

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