Forecasting Default in the Face of Uncertainty

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Abstract
We give an empirical assessment of I^2, a structural credit model based on incomplete information. In this model, investors cannot observe a firm's default barrier. As a consequence, I^2 exhibits both the economic appeal of a structural model and the tractable pricing formulae and empirical plausibility of a reduced form model. We compare default probability and credit spread forecasts generated by I^2 and the well-known structural models of Merton (1974) and Black & Cox (1976). We find that I^2 reacts more quickly to new information and, unlike the other two models, it forecasts positive short term credit spreads.