Does debt structure matter? Estimating contractor default barrier by the down‐and‐out call option approach

Abstract

The down‐and‐out call option approach was used to analyse contractor financial risk under shorter‐term debt structures. The maximum likelihood method was applied to estimate contractor default barriers and probabilities implied by stock prices series and actual debt maturities calculated from historical debt data. Results indicate that the default barriers implied by shorter‐term debt structures are higher than previous estimates using longer‐term debt structures. Further regression analysis shows that implied barriers do not reflect the full effects of asset quality in ameliorating financial distress. Hence, the implied default barriers tend to be higher than the actual default barriers. When applying the DOC approach, if the implied barrier is not calibrated to reflect the borrower’s asset quality, the barrier will tend to overestimate default probability. This has important implications on contractor financial risk monitoring, security pricing and short‐term financial planning.

Keywords:

• Financial risk
• down‐and‐out call option
• maximum likelihood method
• regression analysis
• financial planning