Accounting-based versus market-based cross-sectional models of CDS spreads

Models of financial distress rely primarily on accounting-based information (e.g. [Altman, E., 1968. Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. journal of Finance 23, 589609; Ohlson, J., 1980, Financial ratios and the probabilistic prediction of bankruptcy. journal of Accounting Research 19, 109-131]) or market-based information (e.g. [Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. journal of Finance 29, 449-470]). In this paper, we provide evidence on the relative performance of these two classes of models. Using a sample of 2860 quarterly CDS spreads we find that a model of distress using accounting metrics performs comparably to market-based structural models of default. Moreover, a model using both sources of information performs better than either of the two models. Overall, our results Suggest that both sources of information (accounting - and market-based) are complementary in pricing distress. (C) 2008 Elsevier B.V. All rights reserved.