Testing the Hypothesis of the Adequacy of the Distance-To-Default as an Indicator of Changes in Banks’ Risk Exposures
A distance to default indicates the distance measured in standard deviations of the market value of assets from the default point. The hypothesis that distance to default is indicative of changes in the levels of risk of the banking system since it precedes accounting data that indicate similar changes was tested on the basis of selected financial ratios. We have applied a modification developed by Toda and Yamamoto of the standard Granger causality test to see whether there is causality between distance to default and the selected financial ratios. Contrary to expectations, we could only prove Granger causality from lagged values of distance to default (6 – 12 months) to a leverage ratio, whereas we were not able to obtain similar relationship with other ratios.
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