Fundamental Information and Firm-level Risk

Jorge A Chan-Lau

Financial linkages, which can be as simple as a loan or as complex as a structured product, connect financial institutions and non-financial corporations with each other. The interconnectedness of the financial system, while beneficial, can transmit stresses affecting one institution to a host of others. In an extreme case, the failure of one institution can trigger a domino effect, bringing down other institutions.

The possibility that a single default can trigger system-wide defaults requires assessing the viability of an institution from a standalone basis or, in other words, calculating its probability of default. The choice of the appropriate method for performing this calculation is mainly guided by data availability. Typical data sources include financial statements data, ratings and the prices of securities issued by the firm. Estimates obtained using different data or the same data but different methods should be used to ensure consistency.

This chapter will focus on fundamentals-based methods for estimating probabilities of default. These methods rely on financial data typically used for stock valuation and ratings analysis, mainly financial ratios. One advantage of