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Credit Risk : Merton Model Limitations

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Evaluate of the Merton Model for credit risk analysis

The KMV-Merton model proposed by Robert Merton(1974)is an application of classic option pricing theory and as a logical extension of the Black-Scholes(1973)option pricing framework.Merton’s approach assess the credit risk of a firm by characterizing the firm’s equity as a call option on the underling value of the firm with a strike price equal to the face value of the firm’s debt and a time-to-maturity of T.By put-call parity,the value of the firm’s debt is equal to the value of a risk-free discount bond minus the value of a put option written on the firm with a strike price equal to the face value of debt and a time-to-maturity of T.

To some extent,our calculated probability of default is reasonable.In fact,dynamics of default probability comes mostly from the dynamics of the equity values.KMV model can always quickly reflect deterioration in credit quality.Normally, changes in EDF tend to anticipate at least one year earlier than the downgrading of the issuer by rating agencies such as S&P’s and Moody’s.It recognizes that the market value of debt is unobservable and thus use equity to infer debt value.
The calculated probability of default is more related to the firm’s characteristics than credit rating approach and thus more sensitive to change in the quality of obligors.Because stock price information is predictive and highly responsive, the use of market information to compute credit risk can gain more accurate result.

However there are also some weaknesses of this approach that may lead to the inappropriate probability of default.Our estimation of probability of default requires subjective estimation of the input parameters.We estimate volatility of equity from historical stock returns data and thus the market value and volatility of the firm’s asset,assuming one year forecasting horizon.Because…...

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