A1314
Title: Endogeneity, heterogeneity, and corporate default risk: A correlated random effects panel approach
Authors: Chien-Ho Wang - National Taipei University (Taiwan) [presenting]
Yi-Chi Chen - National Cheng Kung University (Taiwan)
Abstract: A parametric panel framework is developed for predicting corporate probabilities of default that explicitly addresses endogeneity arising from persistent firm-level heterogeneity. In corporate finance, financial policies such as leverage are systematically related to underlying firm risk. When these persistent features are unobserved, conventional logit, probit, and hazard models may confound cross-sectional risk differences with the effects of financial variables. The focus is therefore on correlated heterogeneity, and a correlated random effects design is adopted rather than an instrumental variable method. The specification embeds a control function type adjustment within a discrete-time forward hazard model. A longer time dimension strengthens the approximation, as time averages more precisely summarize persistent components of firm behavior, thereby improving the quality and stability of the correction. Estimation proceeds by random effects probit maximum likelihood, and economic magnitudes are reported through average partial effects. The resulting framework provides a theoretically coherent and empirically tractable approach to PD estimation, enhancing the credibility and interpretability of default risk assessment for financial institutions, investors, and regulators.
