Chapter 2

Statistical Models In Credit Risk Measurement

What is a significant relationship between default tendencies and key observables of a borrower? Statistical techniques are often used to answer this question. In essence, a good credit assessment methodology should be able to suggest a relationship of the form,

p it = f ( X i,t k ) where pit is the probability that the i th borrower will default at time t and X i,t k is the vector of observables at time t k for borrower i . The relationship could be
linear as well as non linear. We briefly study the two commonly used the statistical techniques employed to estimate default probability.

2.1 Altman Z Score

The Z-Score is a measure of a company's health and utilizes several key ratios for its formulation. 1 The model incorporates five weighted financial ratios into the calculations of the Z-Score. The model is continuously being updated incorporating new information. The basic description as well as further calibration on this model can be found in Altman (1993). The Altman Z-score uses the Linear Discriminant Analysis (LDA) to identify 5 key ratios that can predict bankruptcy for public and private companies. The five key ratios are

X 1 = Working Capital/ Total Assets X 2 = Retained Earnings/ Total Assets

X 3 = Earnings before Interest and Taxes (EBIT)/ Total Assets

X 4 = Market Value of Equity/ Total Assets

X 5 = Net Sales/ Total Assets
The Z Score for any firm can be calculated using either of the following two formulas.

The model was developed in Altman (1968).

Z = 1.2 X 1 + 1.4 X 2 + 3.3 X 3 + 0.6 X 4 + 1.0 X 5 ... ........ Z = 6.56 X 1 + 3.26 X 2 + 6.72 X 3 + 1.05 X 4 ... ........

............... ...............

(Z - Public) (Z - Private)

The Z-Score model is easy to calculate and interpret. This makes it one of the most widely used credit scoring models. Note that, higher is the calculated Z-Score of a firm, healthier it is. Once the respective ratios for a company is calculated (publicly or privately held), the respective formulas are used to calculate the Z Score. A healthy public company has a Z >2.99; it is in the grey zone if 1.81 < Z < 2.99; it is unhealthy if it has a Z < 1. 81. A healthy private company has a Z >2.60; it is in the grey zone if 1. 1 < Z < 2.59; it is unhealthy if it has a Z <1.1.

Example 2.1: ABC Ltd. has ( in Rs crores) Total Assets of 200, Working Capital of 20, EBIT of 40, Net sales of 50, retained earnings of 15 and a market va lue of equity equal to 35. Therefore the corresponding values of X 1 , X 2 , X 3 , X 4 and X 5 are 0.2, 0.15, 0.4, 0.35 and 0.5 respectively. The calculated Z Score is 2.48- it is in the indeterminate zone.

Although the Z Score is simple to use, it has its own pitfalls. Few of the stumbling blocks one would encounter in applying Z-Score are listed below Data: Obtaining the data on market value of equity non listed companies is often the first stumbling block. Although approximations can be done to proxy market value of equity, this is often inaccurate. Moreover, for newly listed companies, approximate estimates are often far too inaccurate to proxy market value of equity. Multicollinearity: If two or more explanatory variable are linearly dependent upon each other, one encounters the multicollinearity problem in regression estimation.2 Observe the right hand side of the Z Score model. Theoretically as well as empirically, one would expect a positive correlation between Net sales, EBIT and Retained Earnings. This makes the model suffer from multicollinearity. This means, there is unnecessary bias towards a firm who will be classified into non default zone if net sales are higher. One can expect that if the net sales are higher, then so will be EBIT and retained earnings. In other words, the variables EBIT and Retained earnings are not adding any significant information to the model over and above what net sales has done. In fact, this is the classic case of double counting. One possible method of overcoming the multicollinearity problem is to omit all but one variable
2

See Gujarati (1995)

that are linearly dependent upon each other. However, that would mean a different model with different explanatory variables. Non Determinant Zone: Consider, a public company that has a calculated Z-Score between 1.81 and 2.99. The model does not help in classifying this company into either of the two group- likely to be financially solvent or insolvent. Actual data of companies are likely to classify more companies in the indeterminate zone. If we revisit the objective of credit scoring models, it is obvious to say that, there are large percentage of companies who could be correctly classified in one group or other without resorting to much sophisticated models. However, for equally large percentage of those who could not be classified accurately, are the ones who lie in the indeterminate zone prescribed by Altman Z-score.

2.2 Linear Discriminant Analysis In order to arrive at the explicit functional form, Altman uses the LDA. The basic problem in LDA is as follows. Consider a total sample of n firms. Suppose we have two groups 3 for which we have observations on k explanatory variables. The two groups ha ve n1 and n 2 observations each. LDA is a technique that allows us to construct a linear function of the

k variables that we can use to predict that a new observation belongs to one of the two
groups.

Let us visit the simple algorithm to construct a Linear Discriminant Function (LDF). Suppose, we have data on n firms- n1 defaulters, and n 2 = n n1 non defaulters. The LDF is a function defined over k explanatory variables, x1 , x2 ,..., x k such that Z = 0 +

x
i=1

i i

For the best predictability, it must be the case that i s are chosen such that the ratio,

F=

between - group variance of Z within - group variance of Z

is maximum.

One possible way of doing it is define,

In this case the two groups are bankrupt and solvent.

n1 y= n2

if the individual belongs to group 1 if the individual belongs to group 2

Now estimate the multiple regression equation,

y = 0 + 1 x1 + 2 x 2 + .... + k x k + u

and the Residual Sum of Squares (RSS). Finally calculate the Get the estimates i
coefficients of the LDF using, 4

= n1 + n2 2 i i RSS
Note that, whether explanatory variable x i should appear in the LDF or not, depends upon

. statistical significance of i

2.3 Regression Based Models Linear Probability Models(LPM)

Another approach of estimating probability of default is to estimate the multiple regression equation,

p = 0 + 1 x1 + 2 x 2 + .... + k x k + u .. (LPM 1)
where, p is the probability of default and x 0 , x1 ,..., xk are the k explanatory variables. The above estimated equation is the Linear Probability Model (LPM). Note that the term linear is used to indicate that the probability of default is linearly dependent on the parameters

0 , 1 ,..., k .
Note that while estimating (LPM 1), we will not observe the probabilities of default, instead observe whether a firm has defaulted or not. Therefore, in the regression, we will regress an indicator variable y on x 0 , x1 ,..., xk . Note that y is a dichotomous variable with possible values 5

1 y= 0
4

if the firm has defaulted if the firm has not defaulted

For details see Maddala (1983).

Estimating the (LPM1) along with the indicator variable y will give us the estimated

0 , 1 ,..., k .
Example 2.2: Suppose we regress default probabilities on two variables- x1 -the debt equity ratio (measured as book value of debt to market value of equity) and x 2 - the liquidity ratio. Typical regression outputs using Linear probability Models may appear as;

p = 0.001 + 0.012 x1 0.004 x 2 (3.12) (3.22) (2.45) ; R 2 = 0.56

The figures in the parantheses indicate the students t -ratio. 6 The adjusted R square( R 2 ) indicates that 56% of the fluctuations in the explained variables are explained by fluctuations in explanatory variables. While, R 2 may not be a good indicator of the models predictive capabilities (we will discuss in details a good prediction indicator of such models in the next chapter), nonetheless let us interpret the above equation.

The signs look alright. This is perhaps the most basic check before we start adopting in regression output for interpretation. The variables should have proper signs. We would in general expect that as the leverage increases or the liquidity position of a borrower deteriorates, the default probability would increase. Therefore, the signs corresponding to variable x1 should be positive while that of x 2 should be negative. The above equation seems to beha ve well in this respect.

The probability of default for any particular borrower can be predicted once we know its debt equity ratio and its liquidity ratio. Therefore, if two firms A and B have the same liquidity ratio at say 0.5 while the debt equity ratio for A is 1.1 while that of B is 0.7, then,

p A = 0.001 + 0.012 * 1.1 0.004 * 0.5 = 0.0122; p B = 0.001 + 0.012 * 0.7 0.004 * 0.5 = 0.0074

For obvious reasons, such models are often called Limited Dependent Variables or Dummy dependent Models. Under certain conditions (see Gujarati, 1995), a high t-ratio indicates that the variables have significant impact of the explained variable. Usually a t-ratio exceeding 2 would suffice as high.
6

If the debt equity ratio increases by 1%, the probability of default increases by 0.012%. For A and B in our example, A should have a higher probability of default than B by an amount (1.1-0.7)*0.012=0.0048. Indeed this can be verified by computing the two default probabilities separately ( p A = 0.0122; p B = 0.0074 ).

The LPM is therefore a simple model to use. However, one immediately encounters three problems with the LPM. Goodness of Fit: Consider the scatter plot below in Figure 2.1. The plot is of 32 companies with 13 defaulters and 19 non defaulters. The explanatory variable is debt equity ratio. Note that the scatter plots, imply that the observations either all lie on y = 0 or y = 1. Therefore, any line we wish to fit that is closest to all the observations, will have very low explanatory power. From the data set given in Statistical data.xls check that the R 2 = 0.62 . Figure 2.1:

LPM Plot
1.4 1.2 1 0.8 0.6 0.4 0.2 0 -0.2 0

Default Probability

y Estimated Line

0.2

0.4

0.6

0.8

Debt Equity Ratio

Improbable Probability Estimates: In figure 1, the estimated default probability line as a function of debt equity ratio, is

p = 0.29 + 2.10.x .. (LPM Estimated)

where x , the explanatory variable, is the debt equity ratio of the borrower. The estimated LPM can be interpreted as follows. One percentage increase (or decrease) in leverage ratio increases (or decreases) default probability of a firm by approximately 2.1%. Consider, firms

that have debt equity ratios either (a) less than 0.137 or (b) more than 0.62. For the first group of firms, the estimated probability of default is negative while for the second group, the estimated default probability exceeds one! A closer inspection of the problem will suggest that this problem will always be present with LPMs and not only particular to this example. Linear Incremental Effect of variables on Default Probability: Consider, two firms which have very different leverage ratios. The coefficients of LPM suggest that, the incremental effect of a percentage increase in leverage ratio has identical effect on default probability for both the firms. This is highly improbable. Firms that have considerable high leverage ratio are incrementally more prone to default for a percentage point increase in leverage ratio than firms who has low leverage ratio. To overcome this problem, we will need to estimate a probability model where the incremental effects are non linear. In other words, an increase in leverage ratio of 1% should have differential impact on the default probability, based upon the current leverage ratio.

Considering the above three criticisms, it appears that a more reasonable probability function should appear as one given in Figure 2.2. The plotted probability function is non linear both in parameters as well as the explanatory variables. This will solve, to a large extent, the three problems of LPM encountered above. Note that, the cumulative probability function asymptotically approaches 0 and 1 when the value of explanatory variable is too small or too large . Therefore, the problem of obtaining improbable estimates are immediately done away with. The crucial question is: How do we estimate such non linear probability functions?

Figure 2.2
Reasonable Probability Function 1.2 Deafult probability 1 0.8 0.6 0.4 0.2 0 -40 -20 0 20 40 Explanatory variable Reasonable Probability Function

We discuss the intuition, methodology and estimation techniques involving non linear probability functions in the next chapter.

Exercises and Problems:

2.1: ABC Public Ltd. company and MNC Pvt. Ltd are both in the pharmaceutical industry.
ABC has ( in Rs crores) Total Assets of 2000, Working Capital of 546, EBIT of 540, Net sales of 800, retained earnings of 630 and a market value of equity equal to 350. MNC Pvt. Ltd has ( in Rs crores) Total Assets of 1000, Working Capital of 400, EBIT of 200, Net sales of 600 and retained earnings of 200. According to the Altman Z score, which of the two has lower chances of default?

2.2: Suppose a Linear Probability Model of default estimated using 300 public firms and 220 private firms are as follows:

p publ = 0.84 0.04 x1 0.1x2 0.3x 3 0.22 x 4 0.84 x5 (3.12) (2.22) (1.45) (0.78) (1.41) (2.76) p pvt = 0.92 0.36 x1 0.45 x 2 0.46 x 3 0.88x 5 (2.86) (2.45) (0.79) (0.56)
In the above equations, the legends are;
p pub = Probabilit y of default for a public firm p pvt = Probabilit y of default for a private firm x1 = Working Capital/ Total Assets x2 x3 x4 x5 = Retained Earnings/ Total Assets = EBIT/ Total Assets = Market Value of Equity/ Total Assets = Net Sales/ Total Assets

; R 2 = 0.82 ; R 2 = 0.90

(3.12)

The figures in the parentheses are the t-ratios.

Refer to the companies ABC Public Ltd. company and MNC Pvt. Ltd in the previous problem. 1. Interpret the above two LPM equations. 2. What is the probability of default for ABC Public Ltd? 3. What is the probability of default for MNC Pvt Ltd? 4. How does your answer compare to those obtained in the previous exercise.

5. Which of the two approaches would you follow for default estimation regarding ABC and MNC ltd? 6. How would you update your result if the total assets of MNC Pvt Ltd is found tom be Rs 900 crores? 7. According to you, which are the key ratios that can explain default probabilities? 8. Given a chance, would you have performed the regressions differently? Why and how? 2.3 (Detailed Exercise) Refer to the data given in the accompanying CD. For the Year 2003, develop default probability models based on Linear Discriminant Analysis (Altman Score variables) Linear Probability Model (Altman Score variables) Linear Discriminant Analysis (Variables of your choice) Linear Probability Model (Variables of your choice) Test your findings on the data for 2004. Which one according to you fits better?