Default Prediction Around the World: The Effect of Constraints on Pessimistic Trading

We examine how constraints on pessimistic trading affect the ability to assess a firm’s likelihood of default using publicly available sources of information. Using cross-country differences in short selling as our primary empirical proxy for the ability of market participants to trade pessimistically, our results indicate that a dynamic multiperiod logit model accurately predicts 18 percentage points more actual occurrences of default in countries where short-selling is widely practiced. We find little evidence that short selling restrictions reduce the proportion of inaccurately classified non-default observations. These associations are further identified using time-series variation in the introduction of put option trading. Finally, in countries that face significant pessimistic trading constraints, we document that the direct incorporation of accounting information leads to a greater improvement in default prediction accuracy, particularly where financial reporting transparency is relatively high. _____________________________ We are grateful to the Risk Management Institute for providing the dataset on cross-country default used in this study. Srinivasan acknowledges research support from research grants from the Risk Management Institute at the National University of Singapore. Financial support from the University of Chicago Booth School of Business and the University of Rochester Simon School of Business is gratefully acknowledged. We are grateful for helpful comments received from Ray Ball, Bill Beaver, Mark Lang, Mike Minnis, Shiva Rajgopal, Wendy Wilson, and workshop participants at Emory University, Rice University, the University of Rochester, the Darden International Finance Conference, the 2013 FARS Mid-year Meeting and the 2013 EAA Annual Meeting. * Corresponding author. Tel.: +17737029656; [email protected].