TheMerton model,[1] developed byRobert C. Merton in 1974, is a widely used "structural"credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing the generalpossibility that it will go intocredit default.[2]
Under this model, the value of stock equity is modeled as acall option on thevalue of the whole company – i.e. including the liabilities –struck at the nominal value of the liabilities; and the equity market value thus depends on the volatility of the market value of the company assets. The idea applied is that, in general, equity may be viewed as a call option on the firm: since the principle oflimited liability protects equity investors, shareholders would choose not to repay the firm's debt where the value of the firm is less than the value of the outstanding debt; where firm value is greater than debt value, the shareholders would choose to repay – i.e.exercise their option – and not to liquidate. SeeBusiness valuation § Option pricing approaches andValuation (finance) § Valuation of a suffering company.
This is the first example of a "structural model", where bankruptcy is modeled using a microeconomic model of the firm'scapital structure. Structural models are distinct from "reduced form models" – such asJarrow–Turnbull – where bankruptcy is modeled as a statistical process. By contrast, the Merton model treatsbankruptcy as a continuousprobability of default, where, on the random occurrence ofdefault, the stock price of the defaulting company is assumed to go to zero.[3] This microeconomic approach, to some extent, allows us to answer the question "what are the economic causes of default?"[4]Large financial institutionsemploy default models of both the structural and reduced-form types.
The practicalimplementation of Merton’s model has received much attention in recent years.[5]One adaption is theKMV Model, now offered throughMoody's Investors Service.[6]The KMV Model modifies the original in[5][7] defining the probability of default - or "Expected Default Frequency" - as a function of the "Distance to Default", being the difference between the expected asset value at the analysis horizon and the "default point" normalized by the standard deviation of (future) asset returns. This default point, in turn, is not simply all debt as above, rather, it is the sum of allshort term debt and half thelong term debt.
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