Performance of default risk model with barrier option framework and maximum likelihood estimation: Evidence from Taiwan

We investigate the performance of a default risk model based on the barrier option framework with maximum likelihood estimation. We provide empirical validation of the model by showing that implied default barriers are statistically significant for a sample of construction firms in Taiwan over the period 1994–2004. We find that our model dominates the commonly adopted models, Merton model, Z-score model and ZETA model. Moreover, we test the n-year-ahead prediction performance of the model and find evidence that the prediction accuracy of the model improves as the forecast horizon decreases. Finally, we assess the effect of estimated default risk on equity returns and find that default risk is able to explain equity returns and that default risk is a variable worth considering in asset-pricing tests, above and beyond size and book-to-market.