Macroeconomic Covariates of Default Risk: Case of Pakistani Non-Financial Firms

Abstract

Empirical estimation of default probability through structural approach in the context of macroeconomic dynamics turn out be an emerging idea. However, various aspects of these studies are still needs to be explored to make these models more reliable. This study explored the structural model of default risk (Moody’s KMV) application with macroeconomic dynamics in Pakistani non-financial firm’s context and confirm whether Moody’s KMV model of default prediction could be applicable in Pakistan where the markets are highly speculative and stock markets are highly volatile. The study approximate about the expected default frequency (hereafter EDF) of 307 Pakistani non-financial firms, categorized in 12 industries for a span of 8 years from 2004 to 2011. It further check the macroeconomic variables effects on EDF with the use of generalized method of moments (hereafter GMM). Empirical results compared with the real life scenarios over the said years and on the basis of results we infer that Moody’s KMV model can predict default probability in a much better way than traditional ratio based approach