Examining what best explains corporate credit risk: accounting-based versus market-based models

Abstract

Using a sample of 2,186 credit default swap (CDS) spreads quoted in the European market during the period 2002-2009, this paper empirically analyzes which model ¿ accounting- or market-based ¿ better explains corporate credit risk. We find that there is little difference in the explanatory power of the two approaches. Our results suggest that both accounting and market data complement one other and thus that a comprehensive model that includes both types of variables appears to be the best option for explaining credit risk. We also show that the explanatory power of accounting- and market-based variables for measuring credit risk is particularly strong during periods of high uncertainty, as experienced in the recent financial crisis, and that it decreases as the CDS contract matures. Finally, the comprehensive model continues to show the best results when using the credit rating as the proxy for credit risk, but accounting variables currently appear to have a more important role than the market variables.