What is Merton Model?

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The Merton model is a mathematical formula that stock analysts and commercial loan officers, among others, can use to judge a corporation’s risk of credit default. Named for economist Robert C. Merton, who proposed it in 1974, the Merton model assesses the structural credit risk of a company by modeling its equity as a call option on its assets.

Definition

The Merton Model is a mathematical formula used by stock analysts and commercial lenders to assess the risk of a company's credit default. Proposed by economist Robert Merton in 1974, the model evaluates a company's structural credit risk by modeling its equity as a call option on its assets.

Origin

The Merton Model was first introduced by Robert Merton in 1974 as a tool for assessing corporate credit risk. It is based on the Black-Scholes option pricing model, utilizing option pricing theory to analyze risks within a company's capital structure.

Categories and Features

The Merton Model is a type of structural credit risk model, characterized by treating a company's equity as a call option on its assets. It is applied in scenarios such as evaluating a company's default probability and debt value. Its advantages include providing deep insights into a company's capital structure, but it is highly dependent on market data.

Case Studies

A typical case is Enron Corporation. Before its bankruptcy, analysts could use the Merton Model to assess its high-risk capital structure. Another example is Lehman Brothers, where the Merton Model could help identify its potential default risk before the financial crisis.

Common Issues

Common issues investors face when using the Merton Model include the high accuracy requirement for market data and the restrictive nature of the model's assumptions, such as market efficiency and stable asset volatility.

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