Investigating the Viability of Applying a Lower Bound Risk Metric for Altman’s z-Score

Abstract

The study aimed to build a risk metric for finding the lower boundary limits for Altman’s z-score bankruptcy model. The new metric included a volatility of Altman’s variables and predicted the riskiness of a firm bankrupting in adverse situations. The research examined whether the new risk metric is feasible and whether it provides satisfying outcomes compared to Altman’s z-score values during the same period. The methods to conduct the analysis were based on Value at Risk methodology. The main tools used in constructing the model were Monte Carlo simulation, Lehmer random number generator, normal and t-distribution, matrices and Cholesky decomposition. The sample firms were selected from FTSE 250 index. The important variables used in the analysis were all Altman’s z-score variables, and the period under observation was 2001–2007. The selected risk horizon was the first quarter of 2008. The first results were promising and showed that the model does work to the specified extent. The research demonstrated that Altman’s z-score does not provide a full and accurate overview. Therefore, the lower bound risk metric developed in this research, produces valuable supplementary information for a well-informed decision making. To verify the model, it must be back- and forward tested, neither of which was carried out in this research. Furthermore, the research elaborated on limitations and suggested further improvement options for the model.