A New Approach for Firm Value and Default Probability Estimation 

beyond Merton Models 

Dean Fantazzini∗ Maria Elena De Giuli† Mario Maggi ‡ 
May 2007 
Abstract 
In  this  paper  we  present  a  new  model  to  assess  the  firm  value  and  the  default  probability  by  using  a  bivariate 
contingent  claim  analysis  and copula theory. First we discuss an unfeasible case, given the current derivative market 
on  corporate  bonds,  which  involves  univariate  digital  options  to  compute  the  risk  neutral  probabilities.  We  then 
discuss  a  feasible  model,  which  considers  risky  interest  rates,  instead.  Moreover,  we  develop  in  this  framework  a 
new  methodology  to  extract  default  probabilities  from  stock  prices,  only,  going  beyond  the standard KMV-Merton 
model.  Besides,  the  non-  observability  of  the  Merton  model’s  state variable, numerical methods are needed, but the 
results  can  be  unstable  with  noisy  risky  data. We show how the null price can be used as a useful barrier to separate 
an  operative  firm  from  a  defaulted  one,  and  to  estimate  its  default  probability.  We  then  present  an  empirical 
application with both operative and defaulted firms to show the advantages of our approach. 
Keywords: Firm value, No arbitrage, Structural models, Bivariate option, Copula JEL classification: G12, G30, G32. 
∗Moscow School of Economics, Moscow State University, Russia. E-mail1: fantazzini@mse-msu.ru, E- mail2: 
deanfa@eco.unipv.it. This is the working paper version (before revision) of the paper A New Approach for Firm Value and 
Default Probability Estimation beyond Merton Models, forthcoming in Computational Economics. 
†Department of Business Studies, University of Pavia, via S. Felice, 7, 27100 Pavia, Italy. E-mail: elena.degiuli@unipv.it 
‡Department of Business Studies, University of Pavia, via S. Felice, 7, 27100 Pavia, Italy. E-mail : maggma@eco.unipv.it 

1 
 
1 Introduction 
Merton-type models (or structural models) base the evaluation of firm related securities on 
the structural firm variables, i.e. the firm’s assets and liabilities values. These models date 
from the early seventies (see Merton (1970), Merton (1977), Bielecki and Rutkowski (2002) 
and Bharath and Shumway (2006)). Both the classic papers by Black and Scholes (1973) 
and by Merton (1974) point out that the liabilities of a corporate firm may be priced 
as plain vanilla options. Needless to say, the straightforward use of the Black-Scholes 
valuation formulas requires some basic assumptions on the behavior of assets, no-arbitrage 
opportunities and continuous hedging. 
A common assumption in Merton-type models (e.g., see Ingersoll (1987), Mason and Mer- 
ton (1985), Merton (1977) and Bharath and Shumway (2006)) is that the value A 
t 

of the 
firm follows a geometric Brownian motion 
dA 
t 

= μ 
A 

A 
t 

dt + σ 
A 

A 
t 

dW 
t 

, 
where W 
t 

is a Wiener process and the drift and volatility coefficients μ 

A 

and σ 
A 
do not 
depend on the capital structure of the firm q 
t 

= B 
t 

/E 
t 

, i.e. on how the assets’ value A 

t 

is 
split into equity value E 
t 

and bonds value B 

t 

. The independence of (μ 

A 

,σ 
A 

) on q 
t 

simply 
translates the Miller-Modigliani theorem (see Miller and Modigliani (1958) and (1961)). 
A basic assumption is that the assets’ value is exogenous, so it can be treated as the 
underlying in an option pricing framework. This means that the assets’ value does not 
depend on the dynamics of the firm related securities, and therefore the equity has a 
residual value. Thus, the equity market value E 
t 

satisfies 
E 
t 

= A 
t 

N(d 
1 

) − e−rTB 
T 

N (d 
2 

), (1) 
where T is the maturity of the firm’s debt, B 
T 

is the face value of the firm debt, r is the 

risk free rate, N(·) is the cumulative standard normal distribution function, d 
1 

is given by 
d 
1 

= 
log(A 
t 

/B 
T 

)+(μ 
σ 
A 

√ 
T 
A 

+ 0.5σ2 A 
)T 
, 
2 
 
√ while d 
2 

= d 
1 

− σ 
A 

T. Under the Merton model assumptions the volatility of the equity 

is 
σ 
E 

A 
t E 
t 

. (2) 
The underlying variable in Merton model cannot be directly observed (i.e., see and Bharath 
and Shumway (2006)). To overcome this problem, the KMV-Merton model (see for ex- 
ample Ronn and Verma (1986)) makes use of the two nonlinear equations (1) and (2) and 
solve them numerically for A 
t 

= 
N(d 
1 

)σ 
A 

. Then, the distance to default can be computed as 

d 
2 

and σ 
A 

, therefore the implied probability of default is 

Pr [A 
T 

≤ B 
T 

] = N(−d 
2 

). 
Moreover, some recent facts have shown that the Merton’s approach can not fit many 
actual situations. For example, consider the Fiat-GM negotiation that took place in 2000 
and 2004. In this case, the value of Fiat’s plants and buildings did depend on how they 
were funded. See Pulito (2002) and SEC (2005) for details. Therefore, the value of physical 
assets can not be exogenous. 
We propose a model that substantially changes the point of view with regard to structural 
models. Owing to the financialization of the economy, it is worth treating the market 
value of the assets as a claim on the traded securities: stocks and bonds. We thus model 
the dynamics of stocks and bonds and then endogenously evaluate the assets. We remark 
that this approach overcomes also the problem of the non-observability of the assets’ value 
(and its volatility). 
First we discuss an unfeasible case, given the current derivative market on corporate 
bonds, which involves univariate digital options to compute the risk neutral probabilities. 
Within this framework, we then develop a feasible approach that considers the objective 
joint probability distribution for stocks and bonds, and discount the bivariate contingent 
claim with a risky discount factor. We also present a simple method to assess the default 
probability by using stock prices, only. 
The sequel of the paper is organized as follows. In Section 2 we present the asset as a 
3 
 
bivariate contingent claim by using copula theory. In Section 3 we discuss the unfeasible 
case with digital options while Section 4 a feasible case with risky interest rates. Section 
5 presents the empirical analysis while Section 6 concludes. 

2 A bivariate contingent claim for firm value 

In order to solve the asset observability issue, we propose treating the asset value as a 
bivariate contingent claim written on the traded securities of the firm, i.e. stocks and 
bonds. Unlike the structural approach, we now directly obtain the assets value from the 
processes of traded, i.e. observable, securities. This way the underlyings are observable, 
while the contingent claim is not. Obviously this approach is suited for quoted firms only, 
but even structural models resort to quoted firms. 
A contingent claim can be written in the general form as 
G(g (S 
1 

(T),S 
2 

(T)) ;T), 
where G(·) is a univariate pay-off function which identifies the derivative, g (·) is a bivariate 
function which describes how the two underlying securities determine the final cash-flows, 
S 
i 

denotes the price of the ith underlying security and T is the contract maturity. 
In this framework, we can express the final value of the firm A 
T 

as 
A 
T 

= G(E 
T 

,B 
T 

;T) = max (E 

T 

+ B 
T 

,0)I 
[(E 
T 

, (3) 
where I is the indicator function. 
While this bivariate pricing problem is quite complex in a standard Gaussian world, the 
evaluation task becomes even more difficult when we consider the well-known evidence of 
departures from normality, given by skewness, kurtosis, smile and term structure effects 
of volatility. Moreover, because of the limited liquidity of many financial assets, such as 
risky bonds, the problem of incomplete markets arises. Given this reality, jointly taking 
into account the non-normality of yields, the yields’ dependence structure and markets 
incompleteness, seems to be a very challenging mission. 
4 
≥0),(0≤B 
T 
≤D)] 
 
A possible way out of this stalemate is to resort to copula theory. The study of copulas 
has originated with the seminal papers by Hoeffding (1940) and Sklar (1959) and has 
seen various applications in the statistics literature. For more details, we refer the inter- 
ested reader to the recent methodological overviews by Joe (1997) and Nelsen (1999), and 
Cherubini et al. (2004) for a discussion of copula techniques for financial applications. We 
deal with a complex non-normal joint distribution by separating two issues: (i) we deal 
with non-Gaussian marginal probability distributions and (ii) we use a copula to combine 
these distributions in a bivariate setting. The bivariate pricing kernel can therefore be 
written as a function of univariate pricing functions. 
When the market is complete, a bivariate contingent claim like (3) can be exactly replicated 
and its price is uniquely determined. Moreover, there is a unique risk-neutral probability 
distribution Q(E,B|F 
t 

), with density function denoted by q(E,B|F 

t 

), which represents 
the market pricing kernel. Remembering that G(E 
T 

,B 
T 

;T) is the bivariate claim pay-off, 

its pricing function g(E 
t 

,B 
t 

;t) can be expressed as 

A 
t 
∞∫ 
0 

∞∫ = g(E 
t 

,B 
t 

;t) = P(t, T) 

G(E 
T 

,B 
T 

;T)q(E 
T 

,B 
T 

|F 
t 

) dE 
T 

dB 
T 

, (4) 
0 

where P(t, T) is the risk-free discount factor, which, for the sake of simplicity, we assume 
independent of E 
T 

and B 
T 

. Thanks to the Sklar’s Theorem (1959), the firm’s value price 

A 
t 

= g(E 
t 

,B 
t 

;t) can be expressed as 

A 
t 
∞∫ 
0 

∞∫ = P(t, T) 
G(E 
T 

,B 
T 

;T)c 
EB 

(F 
E 

,F 
B 

|F 
t 

)· 
0 

·f 
E 

(E|F 
t 

)f 
B 

(B|F 
t 

)dE 
T 

dB 
T 

, 
where c 
E,B 

is the bivariate copula density between stock and bond values, and f 
E 

and 
f 
B 

are the marginal densities. The major drawback of this approach is the need of risk- 
neutral probabilities for both stock and the bond prices: while this is not a problem for 
the former, it becomes a rather difficult task for the latter. The derivatives market for 
corporate bonds is still at its early stages and for a limited number of issues only, while 
5 
 
the bond market itself can be very illiquid. 
A more realistic approach is to consider the objective joint probability distribution for 
stocks and bonds, and discount the bivariate contingent claim with a risky discount factor. 
Furthermore, whenever the bond issues are illiquid or are not traded at all (which is the 
usual case), we can express the bond price as a function of the risky interest rate, instead. 
In this case, relation (4) can be suitably modified: 
A 
∞∫ 
0 
∞∫ ′ t 

= P 
r 

(t, T) 
G(E 
T 

,B 
T 

(i 
T 

);T)c 
E,i 

(F 
E 

,F 
i 

|F 
t 

)· 
0 

·f 
E 

(E|F 
t 

)f 
i 

(i|F 
t 

)dE 
T 

di 
T 

, (5) 
Formula (5) can be further simplified by considering that B 
T 

is known at time t as well 

as P 
i 

(t, T). As a consequence, we need the stock price distribution, only: 

A′′ t 

∞∫ = P 
i 

(t, T) 
G(E 
T 

,B 
T 

;T)f 
E 

(E|F 
t 

)dE 
T 

. 
0 

The previous firm pricing function (5) can be approximated by Monte Carlo methods as 
follows: 
A ̃ 
t 
= P 
i 

(t, T) 
N 1 
N∑ 

G( 
E ̃ 
i,T 

,B 
T ;T). i=1 

(6) 

3 A new approach for default probability estimation: the 

zero-price-probability 
While this approach entails a great improvement in terms of distribution modelling, still 
it has the inconvenient that the lowest value of firm value at time T is equal to the debt 
face value B 
T 

if log-returns are used. However, if we allow the domain of E 

T 

to range from 
−∞ to +∞ and consider prices in levels instead of log prices, this result follows directly: 
Proposition 3.1 The Default Probability can be retrieved by estimating 
Pr [E 
T 

≤ 0] or Pr [P 
T 

≤ 0], given that E 

T 

= SP 
T 

, where P 
T 

is the stock price at time 

T and S is the number of shares. Since P 
T 

= max(P 
T 

,0) is a truncated variable, the 6 

 
Default Probability, or simply the Zero-Price Probability (ZPP), is the probability that P 
T 

goes below the truncation level of zero. 

In order to explain the proposition 3.1, let us consider the following two quantities: 
 
 
E 
T 

= A 
T 

− B 
T 
E′ T 

= A 
T 

= (A 
T 

− B 
T 

) + B 
T 

= E 
T 

+ B 
T 

. 
The meanings and signs of E 
T 

and E′ T 
can be completely different according to the sit- 
uation faced by the firm. This result follows from the fact that when E 
T 

is negative it 
Table 1: Financial meaning and signs of E 
T 

and E′ T 
. 
E 
T 
= A 
T 
− B 
T 
E′ 
T 
= A 
T OPERATIVE Equity belonging asset value 
to shareholders (+) (+) DEFAULTED Loss given default Equity belonging to debtholders 
for debtholders (−) (+) 

represents the loss given default for debtholders, as Table 1 shows. We point out that a 
negative value for E 
T 

is plausible due to its different financial meaning, which is a conse- 

quence of the limited liability in place in all modern western legislations. Besides, losses 
can be theoretically unlimited like profits: just think at the effects of the September the 
11th 2001 attacks on airline companies or of the mad cow and bird flue diseases on agricul- 
ture companies. Therefore, we can resort to probability density functions with negative 
domain, too. 
As a consequence, we can estimate the distant to default simply by using E 
T 

, instead of d 
2 

in Merton’s framework, and the default probability by Pr [E 

T 

≤ 0], since the firm defaults 

when E 
t 
is zero or negative. 
In order to compute at time t the probability that at time t + T in the future the stock 
price will cross the zero barrier and the firm will default, i.e. Pr [P 
t+T 

≤ 0], we can consider 

a generic conditional model for the differences of prices levels X 
t 

= P 
t 

−P 
t−1 

, without the 
log-transformation. 
7 
 
≤ An analytical close-form solution for Pr[P 
t+T 

0] is available in the very special case of 

normal distribution. When this is not the case, simulation methods are required. In the 
latter case, estimating the probability that the price reaches or crosses the zero barrier, 
i.e. the default probability, for a given time horizon T is simple: 
Proposition 3.2 (Firm value and ZPP estimation - General case) 1. Consider 
a generic conditional model for the differences of prices levels X 
t 

, without 
the log-transformation: 
X 
t 

= P 
t 

−P 
t−1 
1/2 t 

∼ i.i.d.(0,1) 
where H 
=E[X 
t 

|# 
t−1 

] + ε 
t 

= H 
η 
t 

, η 
t 
1/2 t 

is the information set 

available at time t. 
2. Simulate a high number N of price trajectories up to time t+T, using the estimated 
time series model. 
3. Estimate the firm pricing function (6) by using the appropriate discount factor 
P 
i 

is the conditional standard deviation, while # 

t 

(t, t + T). The default probability is simply the number of times n out of N when 
the price touched or crossed the barrier along the simulated trajectory. 
This method entails a number of important benefits: 
1. We only need the stock prices and the face value of the debt B 
T 

for estimating the 

firm value A 
t 

. 
2. We do not need the firm’s volatility σ 
A 

, like in Merton-style models. 

3. We can consider more realistic distributions than the log-normal. 
4. We can compute the average loss given default for debtholders, and therefore the 
recovery rate, simply by taking the average of the losses n 1 
i=1 n∑ 

(E 
T,i 
) = n 1 
i=1 n∑ 

(A 
T 

−B 
T 

). 
5. We can estimate the default probability as a by-product of the previous procedure. 
If this is the only object of interest, we can completely disregard the debt value B 
T 

. 
This can be a great advantage when debt accountancy data are poor. 
8 
 
6. We can estimate the default probability for any given time horizon t + T. 
7. We can screen the default risk daily or even intra-daily. For this reason, the ZPP 
can therefore be used as a tool for risk management. 
8. The ZPP can be used as an early warning system for financial default for every 
traded assets. 

4 Empirical analysis 
We first analyze the daily data of thirty stocks composing the American DOW30 index, 
computing both the estimated firm values and the default probabilities. We consider the 
KMV-Merton approach that makes uses of the nonlinear equations (1) and (2) and our 
approach described in Section 3, together with the pricing function (5). In the latter case, 
we consider an AR(3)-Threshold-GARCH(1,1) model with a Student’s t distribution to 
take the leverage effect into account, as well as leptokurtosis in the data, see Glosten et 
al. (1993). The liabilities are the sum of short-term liabilities plus one-half of long term 
liabilities. This assumption, which is made by Moody’s KMV for North American firms, 
ensures that the firms liabilities are not overstated. We then consider four well known 
defaulted stocks. 
4.1 Not-defaulted stocks: the DOW30 components 
In order to estimate the firm values and the default probabilities, we consider a 1-year 
ahead horizon. The first estimation sample is between 01/01/1997 and 13/12/2004: at the 
j-th iteration where j goes from 14/12/2004 to 29/12/2005 (for a total of 265 observations), 
the estimation sample is augmented to include one more observation, and this procedure 
is iterated until all days have been included in the estimation sample. 
The firm values estimated through (6) are generally larger than KMV ones. The difference 
is almost constant over the entire time path.1 The default probabilities are more interest- 
ing, instead. We report in Figures 2-4 the default probabilities of the 12 firms for which 
1In order to save space we do not report the results which are available upon request. 

9 
 
1.0 
0.9 
0.8 
0.7 
0.6 
0.5 
0.4 
0.3 
0.2 
0.1 
0.0 
0.00 0.05 0.10 0.15 0.20 0.25 0.30 

Figure 1: Default probability as a function of the equity-to-debt ratio 

it is not negligible.2 
Our analysis highlights some elements of sure interest, and the major insights can be 
summarized as follows: 
1. The firm value estimated with the KMV-Merton model is always lower than that 
estimated with our approach where the asset value is endogenous. Such a result is 
consistent with previous literature showing that Merton-type models tend to under- 
estimate the asset value (see Dionne (2006), Hao (2006) and Wong and Li (2004)). 
2. The default probability estimated with the ZPP is usually higher than the one ob- 
tained by using Merton’s model.3 It is possible to show that in the latter model 
the default probability raises quickly only when the equity-to-debt ratio is very low, 
everything else kept fixed. We report in Figure 1 a simple study performed with 
average values taken from the DOW30 stocks. 
3. The KMV-Merton model shows numerical instability with noisy data, see the case of 
Boeing in Figure 2. Besides, unreported estimations with General Motors data per- 
2Stock price data and balance sheet data from Bloomberg. 3In some graphs the Merton’s line is not visible: its estimate is nearly 
0. 

10 
 
formed with smaller samples (starting after the year 2000 instead of 1997), resulted 
in default probabilities ranging between 90%-99% for the last three years. 
In general, the debt values reported in the certified balance sheets are underestimated for 
two reasons: 
• to “window dress” the financial health of the company, in the best case (for instance, 
Swissair, see Section 4.2); 
• to hide financial fraud, in the worst case (Parmalat, Cirio, Enron, see Section 4.2) 
Ketz (2003) discusses a wide variety of techniques to hide debts and financial risk. This 
explains why the Merton’s default probabilities and firm values are usually underesti- 
mated with respect to the ZPP. Besides, the log-normal is not an appropriate distribution 
for price dynamics since it underestimates the tail of the distribution. Furthermore, het- 
eroscedasticity is not considered at all in the KMV-Merton model. Increasing volatility 
and leptokurtosis can be interpreted as a signal of informed trading (see Biais et al. (2005), 
and Hansbrouck (2007), for recent surveys about market microstructure studies). 
BOEING.CO 
HONEYWELL.INTL.INC 0.2 
p 
2005 2005.5 2006 
2005 2005.5 2006 
2005 2005.5 2006 
0.03 
0.15 . b o r 
0.1 
. b o r p 
0.02 
0.05 
0.01 
0 
0 
JP.MORGAN.CHASE.CO 
MERCK.CO.INC 0.06 
p 
2005 2005.5 2006 Default prob. ZPP Default prob. KMV 

Figure 2: Estimated Default Probability 

11 
0.1 
p 
0.08 
. b o r 
0.04 
. b o r 
0.06 
0.02 
0.04 
0.02 
0 
0 
 
HEWLETT.PACKARD.CO VERIZON.COMMUN 0.06 
0.1 
0.08 
. b o r p 
0.04 
p 0.02 
2005 2005.5 2006 
2005 2005.5 2006 
. b o r 
0.06 
0.04 
0.02 
0 
2005 2005.5 2006 
0 
ALCOA.INC 
AT&T.INC 0.04 
0.08 
0.03 
0.06 . b o r p 
0.02 
p 
2005 2005.5 2006 Default prob. ZPP Default prob. KMV 

Figure 3: Estimated Default Probability 

2005 2005.5 2006 
. b o r 
0.04 
0.01 
0.02 
0 
0 
MICROSOFT.CP 
PFIZER.INC 0.03 
0.2 
. b o r p 
0.02 
0.15 . b o r p 
0.1 
0.01 
2005 2005.5 2006 
2005 2005.5 2006 
0.05 
0 
0 
INTEL.CP 
GEN.MOTORS 0.06 
0.8 
. b o r p 
0.04 
0.6 . b o r p 
0.4 
0.02 
0.2 
0 
0 
2005 2005.5 2006 Default prob. ZPP Default prob. KMV 

Figure 4: Estimated Default Probability 

4.2 Defaulted stocks 
Given the problems highlighted in the previous section, we focus on the default probability 
only, considering the last 1000 trading days of four famous defaulted stocks:4 
4AR(3)-TGARCH(1,1) models with Student’s T distribution were used to compute the ZPP. Data from Bloomberg. 

12 
 
1. Parmalat: 22/02/2000 - 22/12/2003. Largest default in EU history. 
2. Cirio: 24/09/1999 - 24/07/2003. Second largest default in the Italian food sector 
(the first is Parmalat); 
3. Enron: 20/01/1998 - 10/01/2002. Largest default in American history. 
4. Swissair: 06/02/1998 - 31/01/2002. Largest default in European Airline Industry. 
Parmalat − last 1000 days before default 
0 100 200 300 400 500 600 700 800 900 1000 
22/02/2000 − 22/12/2003 
Enron − last 200 days before default 1.0 
1.0 0.9 
0.9 0.8 
0.8 0.7 
0.7 
. b o r p 
0.6 0.5 
. b o r p 
0.6 0.5 0.4 
0.4 0.3 
0.3 0.2 
0.2 0.1 
0.1 0.0 
0.0 
0 20 40 60 80 100 120 140 160 180 200 13/02/2001 − 03/12/2001 Cirio − last 1000 days before default 
0 100 200 300 400 500 600 700 800 900 1000 
24/09/1999 − 24/07/2003 
Swissair − last 200 days before default 1.0 
1.0 0.9 
0.9 0.8 
0.8 0.7 
0.7 
. b o r p 
0.6 0.5 
. b o r p 
0.6 0.5 0.4 
0.4 0.3 
0.3 0.2 
 0.2 0.1 
0.1 0.0 
0.0 
0 20 40 60 80 100 120 140 160 180 200 12/12/2000 − 03/10/2001 

Figure 5: ZPP (black) and KMV (grey) default probabilities for Parmalat, Cirio, Enron and Swissair. 
Default probabilities for Parmalat, Cirio, Enron and Swissair are reported in Figure 5. For 
Enron and Swissair we report the last 200 trading days only, because for the previous ones 
the probabilities are nearly 0. It’s interesting to observe that already 2 / 3 years before 
the default, the 1-year ahead ZPPs for Parmalat and Cirio were well above 50%. This 
evidence seems consistent with preliminary justice results, which highlight that financial 
distress was already known at the end of the ’90 for both companies. Instead, Figure 5 
shows that the KMV-Merton’s default probabilities are clearly underestimated compared 
to the ZPP. Particularly severe is the underestimation for Parmalat, whose true debt (15- 
18 billion Euros) was more than double that on the balance sheet (7 billion Euros) and 
used to compute the KMV-Merton default probability. Moreover, the KMV-Merton model 13 
 
suffers again from numerical instability and from the jumps in the debt values at book 
closure dates at the end of the year: this produces the one-day peaks shown in Figure 5 
(Cirio) and 2 (Boeing). 
Besides, we can gauge the precision of the estimated ZPPs by Monte Carlo methods: 
1. Draw a 1 × T vector of standardized innovations η from the considered marginal 
density (for example Student’s T). 
2. Create an artificial history for the random variable by replacing all parameters with 
their estimated counterparts, together with the standardized innovations η 
t 

drawn in 
the previous step, which have to be rescaled by the the square roots of the variances √ 
h 
t 

. 
3. Estimate an AR(3)- T-GARCH model, using the data from the artificial history. 
4. Calculate a Monte Carlo estimate of the ZPP using the previous estimates performed 
on the artificial history; 
5. Repeat the above four steps for a large number of times, in order to get a numerical 
approximation to the distribution of the ZPP. 
This distribution forms the basis for computing a bounded kernel density. Two examples 
with Enron and Swissair are reported in Figures 6-7. 
Comparing Figures 5 and 6-7, we can further observe how the ZPPs highlight the different 
efficiency between the Italian market and the American or Swiss markets: while the esti- 
mated ZPPs in the former market were well above 50% already a couple of years before 
the default, in the latter markets this phenomenon took place only in the last 100 trading 
days. 

5 Conclusions 
In this paper we described a bivariate pricing model to assess the firm asset value. First, 
we discussed an unfeasible case where the market is complete and we have full information 
14 
 
enron 
y t i s n e d 
0 20 40 60 
0 
20 
40 
60 
160 
140 
120 
100 
80 
80 
180 100 
200 
t 
zpp 

Figure 6: Bounded kernel density for Enron’s Z.P.P. (last 200 trading days, 23/03/2001 - 10/01/2002) 
d 
0 
50 
100 y t i s n e 
150 
200 
250 
t 
0 10 20 30 40 zpp 
50 60 70 80 90 100 

Figure 7: Bounded kernel density for Swissair’s Z.P.P. (last 200 trading days, 12/04/2001 - 31/01/2002) 
15 
 
from derivatives markets. The major drawback of such a case is the need of risk-neutral 
probabilities for both stock and the bond prices. 
We then proposed a feasible case that consider a bivariate contingent claim with a risky 
discount factor. Within this framework, we developed a new empirical method to compute 
default probabilities and firm values. 
Our approach neither needs any firm’s volatility like in Merton-style models, nor the debt 
face value when the default probability is the only subject of interest. Moreover, we 
can consider more realistic distributions than the log-normal one. Besides, the numerical 
stability of our approach is much better than Merton’s one. Furtermore, the ZPP model 
early identifies the financial distresses earlier than the KMV-Merton model. 
The empirical analysis showed that the Italian markets seems much less efficient than the 
American markets, since the estimated default probabilities in the former market were 
well above 50% already a couple of years before the defaults, while in the latter markets 
this phenomenon took place only in the last 100 trading days. 
An avenue for further research is to perform a back-testing analysis with larger datasets 
so that we can sharpen the comparison between Italian, European and American markets 
in terms of efficiency and forecasting performances. 

References 
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18 
 
A Technical appendix 
We report in this appendix the results of our analysis applied to all the DOW30 firms. 
Figures 8 to 12 show the estimated firm values, whereas in Figures 13 to 17 the estimated 
default probabilities are plotted. For ease of comparison, the default probabilities’ graphs 
are displayed using the same scale (0 to 0.1 probability) for all plots. 
2.5 
x 10 
11 
IBM 
8 
x 10 
10 
CATERPILLAR 
$ S U 
2 
$ S U 
6 
1.5 
2005 2005.2 2005.4 2005.6 2005.8 2006 
4 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2 
x 10 
11 
BOEING 
8 
x 10 
10 
3M 
$ S U 
1.5 
1 
2005 2005.2 2005.4 2005.6 2005.8 2006 
$ S U 
7 
6 
0.5 
5 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2.4 
x 10 
11 
ALTRIA.GROUP 
10 
x 10 
11 
AMER.INTL.GROUP 
$ S U 
2.2 
2 
$ S U 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Asset value KMV Asset value ZPP 

Figure 8: Estimated firm value - stocks DOW30, 14/12/2004 - 30/12/2005 

2005 2005.2 2005.4 2005.6 2005.8 2006 
8 
6 
1.8 
4 
1.6 
2 
5.5 
x 10 
11 
EXXON.MOBIL 
2 
x 10 
11 
PROCTER.GAMBLE 
$ S U 
4.5 5 
4 
$ S U 
1.8 
1.6 
3.5 
1.4 
2005 2005.2 2005.4 2005.6 2005.8 2006 
9 
x 10 
10 
UNITED.TECH 
2.4 
x 10 
11 
JOHNSON.AND.JOHNSON 
$ S U 
8 
7 
2005 2005.2 2005.4 2005.6 2005.8 2006 
$ S U 
2.2 
2 
6 
1.8 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2.5 
x 10 
11 
AMER.EXPRESS 
2 
x 10 
12 
CITIGROUP 
$ S U 
2 
$ S U 
1.5 
1 
1.5 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.5 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Asset value KMV Asset value ZPP 

Figure 9: Estimated firm value - stocks DOW30, 14/12/2004 - 30/12/2005 

19 
 
HOME.DEPOT 3.5 
x 10 
11 
WAL.MART 
1.4 
x 10 
11 
$ S U 
3 
1.2 
U 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
$ S 
1 2.5 
0.8 
2 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.6 
1.3 
x 10 
11 
COCA.COLA 
6 
x 10 
10 
HONEYWELL.INTL 
$ 
1.2 
$ 
5 S U 
1.1 
U 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
S 
4 
1 
3 
1.4 
x 10 
12 
JP.MORGAN 
8 
x 10 
10 
DU.PONT 
$ S U 
1.2 
0.8 1 
$ S U 
7 
6 
0.6 
5 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Asset value KMV Asset value ZPP 

Figure 10: Estimated firm value - stocks DOW30, 14/12/2004 - 30/12/2005 

10 
x 10 
10 
MERCK 
7 
x 10 
10 
MCDONALDS 
$ S U 
8 
$ S U 
6 
5 
6 
2005 2005.2 2005.4 2005.6 2005.8 2006 
4 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2.5 
x 10 
11 
VERIZON.COMMUN 
1.4 
x 10 
11 
HEWLETT.PACKARD 
$ S U 
1.5 2 
$ S U 
1.2 
0.8 1 
1 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.6 
2005 2005.2 2005.4 2005.6 2005.8 2006 
12 
x 10 
11 
GEN.ELECTRIC 
5 
x 10 
10 
ALCOA 
$ S U 
10 
8 
6 
$ S U 
4 
3 
4 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Asset value KMV Asset value ZPP 

Figure 11: Estimated firm value - stocks DOW30, 14/12/2004 - 30/12/2005 

20 
 
WALT.DISNEY 9 
x 10 
10 
2 
x 10 
11 
AT&T 
$ S U 
8 
7 
$ S U 
1.5 
6 
2005 2005.2 2005.4 2005.6 2005.8 2006 
1 
2005 2005.2 2005.4 2005.6 2005.8 2006 
4 
x 10 
11 
MICROSOFT 
3 
x 10 
11 
PFIZER 
$ 
3.5 
$ 
2.5 S U 
3 
2005 2005.2 2005.4 2005.6 2005.8 2006 
S U 
2 
2.5 
1.5 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2.5 
x 10 
11 
INTEL 
5 
x 10 
11 
GM 
$ S U 
1.5 2 
2005 2005.2 2005.4 2005.6 2005.8 2006 
$ S U 
4 
3 
1 
2 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Asset value KMV Asset value ZPP 

Figure 12: Estimated firm value - stocks DOW30, 14/12/2004 - 30/12/2005 

IBM 
CATERPILLAR 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
BOEING 
3M 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
ALTRIA.GROUP 
AMER.INTL.GROUP 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Default prob. KMV Default prob. ZPP 

Figure 13: Estimated default probability - stocks DOW30, 14/12/2004 - 30/12/2005 

21 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
 
PROCTER.GAMBLE EXXON.MOBIL 0.1 
0.1 
. b o r p 
0.05 
. b o r p 
0.05 
0 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0 
2005 2005.2 2005.4 2005.6 2005.8 2006 UNITED.TECH 
JOHNSON.AND.JOHNSON 0.1 
0.1 
. b o r p 
0.05 
2005 2005.2 2005.4 2005.6 2005.8 2006 
. b o r p 
0.05 
0 
0 
2005 2005.2 2005.4 2005.6 2005.8 2006 AMER.EXPRESS 
CITIGROUP 0.1 
0.1 
. b o r p 
0.05 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Default prob. KMV Default prob. ZPP 

Figure 14: Estimated default probability - stocks DOW30, 14/12/2004 - 30/12/2005 

2005 2005.2 2005.4 2005.6 2005.8 2006 
. b o r p 
0.05 
0 
0 
WAL.MART 
HOME.DEPOT 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
COCA.COLA 
HONEYWELL.INTL 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
JP.MORGAN 
DU.PONT 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Default prob. KMV Default prob. ZPP 

Figure 15: Estimated default probability - stocks DOW30, 14/12/2004 - 30/12/2005 

22 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
 
MCDONALDS MERCK 0.1 
0.1 
. b o r p 
0.05 
. b o r p 
0.05 
0 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0 
2005 2005.2 2005.4 2005.6 2005.8 2006 VERIZON.COMMUN 
HEWLETT.PACKARD 0.1 
0.1 
. b o r p 
0.05 
2005 2005.2 2005.4 2005.6 2005.8 2006 
. b o r p 
0.05 
0 
0 
2005 2005.2 2005.4 2005.6 2005.8 2006 GEN.ELECTRIC 
ALCOA 0.1 
0.1 
. b o r p 
0.05 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Default prob. KMV Default prob. ZPP 

Figure 16: Estimated default probability - stocks DOW30, 14/12/2004 - 30/12/2005 

2005 2005.2 2005.4 2005.6 2005.8 2006 
. b o r p 
0.05 
0 
0 
WALT.DISNEY 
AT&T 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
MICROSOFT 
PFIZER 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
2005 2005.2 2005.4 2005.6 2005.8 2006 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0 
INTEL 
GM 0.1 
p 
2005 2005.2 2005.4 2005.6 2005.8 2006 
Default prob. KMV Default prob. ZPP 

Figure 17: Estimated default probability - stocks DOW30, 14/12/2004 - 30/12/2005 

23 
0.1 
. b o r 
0.05 
. b o r p 
0.05 
0 
0