Merton Unraveled

Abstract

Popular approaches to default probability estimation are often based on the approach initially described in Merton [1974]. By explicitly modeling a firm's market value, market value volatility and liability structure over time using contingent claims analysis the Merton model defines a firm as defaulted when the firm's value falls below its debt. This article demonstrates how a simplified “spread sheet” version of the Merton model produces distance to default measures similar to the original Merton model. Moreover, when applied to a sample of US firms, the simplified model gives a relative ranking of firms that is essentially unchanged compared to the Merton model.

TOPIC: Risk management