Understanding Credit Risk for Chinese Companies using Machine Learning: A Default-Based Approach

76 Pages Posted: 23 Nov 2020 Last revised: 12 Mar 2021

See all articles by Edward I. Altman

Edward I. Altman

New York University (NYU) - Salomon Center; New York University (NYU) - Department of Finance

Xiaolu Hu

RMIT University - School of Economics, Finance and Marketing

Jing Yu

The University of Sydney; Financial Research Network (FIRN)

Date Written: March 12, 2021

Abstract

In response to the recent elevated corporate credit risk environment in China’s credit market, we develop a probability of default (PD) measure for Chinese companies using actual corporate bond defaults by applying the Least Absolute Shrinkage and Selection Operator (LASSO) machine learning model. Our PD measure is applicable to publicly listed and also, importantly, to unlisted companies. Our measure’s bond default prediction accuracy outperforms models generated by alternative machine learning techniques and other prominent credit risk measures. Further analysis documents a large pricing effect of corporate default risk using our PD measure in primary and secondary bond markets. The pricing effect of default risk became more pronounced following two crucial market events in 2014 that raised market awareness of credit risk and is stronger for bonds likely traded by retail and foreign investors. In the cross section of bond and stock returns, we observe a positive distress risk premium after controlling for common risk factors. Finally, stocks of low PD firms outperformed those of high PD firms during the COVID-19 pandemic.

Keywords: Default risk; Chinese bond market; Z-score; Distress risk premium

JEL Classification: G12; G15; G23; G24

Suggested Citation

Altman, Edward I. and Hu, Xiaolu and Yu, Jing, Understanding Credit Risk for Chinese Companies using Machine Learning: A Default-Based Approach (March 12, 2021). NYU Stern School of Business Forthcoming, Available at SSRN: https://ssrn.com/abstract=3734053 or http://dx.doi.org/10.2139/ssrn.3734053

Edward I. Altman

New York University (NYU) - Salomon Center ( email )

44 West 4th Street
New York, NY 10012
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212-998-0709 (Phone)
212-995-4220 (Fax)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Xiaolu Hu

RMIT University - School of Economics, Finance and Marketing ( email )

Level 12, 239 Bourke Street
Melbourne, Victoria 3000
Australia

Jing Yu (Contact Author)

The University of Sydney ( email )

University of Sydney
Sydney, NSW 2006
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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