Estimating default barriers from market information ∗

Brockman and Turtle (2003) develop a barrier option framework to show that default barriers are significantly positive. Most implied barriers are typically larger than the book value of corporate liabilities. We show theoretically and empirically that this result is biased due to the approximation of the market value of corporate assets by the sum of the market value of equity and the book value of liabilities. This approximation leads to a significant overestimation of the default barrier. To get rid of this bias, we propose a maximum likelihood (ML) estimation approach to estimate the asset values, asset volatilities, and default barriers. The proposed framework is applied to empirically examine the default barriers of a large sample of industrial firms. This paper documents that default barriers are positive but not very significant. In our sample, most of the estimated barriers are lower than the book values of corporate liabilities. In addition to the problem with the default barriers, we find significant biases on the estimation of asset value and asset volatility by Brockman and Turtle (2003). JEL classification: G12; G33