Equity Risk, Credit Risk, Default Correlation, and Corporate Sustainability

Abstract

Financial researchers have long understood the theoretical links between equity risk and credit risk. Although structural models of credit risk, such Moody’s KMV, have been available for some time, the author develops a new approach to the use of such models. The author derives the market-implied expected life of a firm based on the firm’s stock price, balance sheet leverage, and the equity risk forecast from his models. The first step is to translate the equity risk forecast into a forecast of the volatility of a firm’s assets. An option framework is then used to derive an expectation of the market-implied expiration date of the option, which is a proxy for the expected life of the firm. Two methods for improving estimates of default correlation are provided. The article also shows empirical uses of the technique at both the firm level as a measure of credit risk and the market level as a metric for systemic risk. Finally, brief evidence is presented that the concept of corporate “sustainability” as broadly used by socially responsible investors appears to be supported, with purportedly sustainable firms having average expected lives that are longer than those of non-sustainable firms to a statistically significant degree.