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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A bank applies the original Altman Z-score to a privately held firm by substituting book equity for market equity in X4, and also wants to apply it to a non-manufacturing service company. Which statement best describes the appropriate response?

The appropriate response is to use the revised models: Z' with book equity and new coefficients and cutoffs for private firms, and Z'' without the sales-to-assets ratio for non-manufacturers. Plugging substitute inputs into the original model misapplies coefficients and cutoffs calibrated to listed manufacturers.

  1. AUse the original model unchanged for both, since coefficients are universal
  2. BUse Z' for private firms and Z'' (without the sales/assets ratio) for non-manufacturers, re-estimating coefficients and cutoffsCorrect
  3. CUse Z'' for private firms and the original Z for non-manufacturers
  4. DUse the original model but double X4 to offset the lack of market data

Explanation

Altman revised the model: Z' uses book equity for private firms with new coefficients and cutoffs, and Z'' drops sales/assets to reduce industry sensitivity, suiting non-manufacturers. Simply swapping inputs into the original coefficients distorts the score and cutoffs.

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