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Replication on Morningstar Financial Health Grade
kai yin chan
posted Sep 12, 2018
Finance Theory Getting Started Research Value Self Serve Data

https://www.quantopian.com/help/fundamentals

Morningstar financial health grade is a convenient tool for users to incorporate distance to default to trading strategies. However, it is not easily accessible outside quantopian platform. Under this motivation, I tried to replicate the calculation of financial health grade.

The method that uses standard estimation on equity volatility gives 43% accuracy of grade A, and 67% accuracy of grade A and B. (on 2018-08-01 data)

Lately, it is interesting that even grade D and F can have a low probaility of default (<0.01). That may due to a narrower range in probaility of default while Morningstar ranks the distance to default instead of probability of default.

I did not include dividend in the calculation. You may try to include that and see the difference.

3 responses
Cal Mitchell
Sep 12, 2018

Interesting work!

One thing to note is that the definition of financial_health_grade on Quantopian's fundamental page says:

"To estimate a distance to default, the value of the firm's liabilities is obtained from the firm's latest balance sheet and incorporated into the model. We then rank the calculated distance to default and award 10% of the universe A's, 20% B's, 40% C's, 20% D's, and 10% F's."

However, Morningstar's site shows that they use other variables to calculate financial_health_grade as well. Their definition reads:

To get a good grade in this area, a company should have low financial leverage (assets/equity), high cash-flow coverage (total cash flow/long-term debt), and a high cash position (cash/assets) relative to its sector.

Maybe you could make this custom factor more robust by incorporating these variables?

Thanks for sharing!

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Mathieu M
Sep 13, 2018

Hey, thanks for sharing, nice implementation of the Merton model !

Here is a comparative when taking dividends into account. It seems more accurate, as it produce the same ranking as financial health grade.

kai yin chan
Sep 16, 2018

@Mathieu Meynier

I saw that you minus the dividend after r_f. But, this document put dividend in d_1 and also G(A_0, sigma_A)

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The material on this website is provided for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation or endorsement for any security or strategy, nor does it constitute an offer to provide investment advisory services by Quantopian.

In addition, the material offers no opinion with respect to the suitability of any security or specific investment. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as none of Quantopian nor any of its affiliates is undertaking to provide investment advice, act as an adviser to any plan or entity subject to the Employee Retirement Income Security Act of 1974, as amended, individual retirement account or individual retirement annuity, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement or other investor, contact your financial advisor or other fiduciary unrelated to Quantopian about whether any given investment idea, strategy, product or service described herein may be appropriate for your circumstances. All investments involve risk, including loss of principal. Quantopian makes no guarantees as to the accuracy or completeness of the views expressed in the website. The views are subject to change, and may have become unreliable for various reasons, including changes in market conditions or economic circumstances.