An Empirical Estimation of Default Risk of the UK
Real Estate Companies
Department of Land Economy, University of Cambridge, 19 Silver Street, Cambridge, CB3 9EP, UK
Department of Land Economy and Harvard University, University of Cambridge, Real Estate Academic
Initiative, 48 Quincy Street, Cambridge, MA 02138, USA
Based on the Black and Scholes [Black, F., and M. Scholes. (1973). The Pricing of Options and Corporate
Liabilities, Journal of Political Economy 81, 637Y659] and Merton [Merton, R. C. (1974). On the Pricing of
Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance 29, 449Y470] (BSM) contingent
claims model, and KMV Corporation framework, we estimate the distance to default and the Brisk neutral^
default probabilities for a sample of 112 real estate companies over the period 1980 to 2001. Our empirical
results classiﬁes failed and non-failed companies into Type I error, cases that the BSM-type model fails to
predict default when it did occur, and Type II error where BSM-type model predicts default when it did not
occur. We ﬁnd that none of the companies belong to the category of Type I error. Type II error is observed
in 12 out of 112 companies. These results support the theoretical underpinnings of the BSM-type structural
model in that the two driving forces of default are high leverage and high asset volatility.
Key Words: credit risk, default probability, real estate companies
Much of the recent development in risky debt valuation owes its origin to the seminal
works of Black and Scholes (1973) and Merton (1974) (hereafter referred to as BSM).
BSM demonstrate how debt and equity can be valued using the option pricing theory.
Two competing strands of approaches, the structural (or alternatively stated as the
contingent claims approach
) and the reduced-form models of credit risk, have
emerged over the past two decades. In the original BSM contingent claims model,
default is assumed to occur when the market value of assets has fallen to a sufﬁciently
low level relative to the ﬁrm’s total liability. Structural models (Longstaff and
Schwartz, 1995; Saa-Requejo and Santa Clara, 1997; Anderson and Sundaresan,
2000; Cossin and Pirotte, 2001), based on the contingent claims approach, rely on the
economic argument that a ﬁrm defaults when its asset value drops to the value of its
contractual obligations. Driven by pragmatic considerations, the reduced form models
(Jarrow and Turnbull, 1995; Dufﬁe and Singleton, 1999), rely on the argument that
default is an event that happens unexpectedly. In the reduced form models, ﬁrst
introduced by Jarrow and Turnbull (1995), and subsequently extended by Jarrow et al.
(1997), the default time is assumed to follow a Poisson distribution and a continuous-
The Journal of Real Estate Finance and Economics, 32:1, 21–40, 2006
2006 Springer Science + Business Media, Inc. Manufactured in The Netherlands.