The Merton model,
developed by
Robert C. Merton
Robert Cox Merton (born July 31, 1944) is an American economist, Nobel Memorial Prize in Economic Sciences laureate, and professor at the MIT Sloan School of Management, known for his pioneering contributions to continuous-time finance, especia ...
in 1974, is a widely used
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
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 general possibility that it will go into
credit default.
Under this model, the value of stock equity is modeled as a
call option on the
value 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 of
limited liability
Limited liability is a legal status in which a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a corporation, company or partnership. If a company that provides limited liability to it ...
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. See .
This is the first example of a "structural model", where bankruptcy is modeled using a microeconomic model of the firm's
capital structure. Structural models are distinct from "reduced form models" – such as
Jarrow–Turnbull – where bankruptcy is modeled as a statistical process.
By contrast, the Merton model treats
bankruptcy as a continuous
probability of default, where, on the random occurrence of
default, the stock price of the defaulting company is assumed to go to zero.
[Robert Merton, "Option Pricing When Underlying Stock Returns are Discontinuous" ''Journal of Financial Economics'', 3, January–March, 1976, pp. 125–44.]
This microeconomic approach, to some extent, allows us to answer the question "what are the economic causes of default?"
[Nonlinear valuation and XVA under credit risk, collateral margins and Funding Costs](_blank)
Prof. Damiano Brigo, UCLouvain
See also
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Credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
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Credit derivatives
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Credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
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Jarrow–Turnbull model
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Probability of default
References
Further reading
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* {{cite book , author1=van Deventer , author2=Donald R. , author3=Kenji Imai , author4=Mark Mesler , title = Advanced Financial Risk Management: Tools & Techniques for Integrated Credit Risk and Interest Rate Risk Modeling , year = 2004 , publisher = John Wiley , isbn = 978-0-470-82126-8
Financial risk modeling
Financial_models
Credit risk
Equity securities