What is the Merton model?

The Merton model, which is named after Robert C. Merton, was developed in the 70s. It has been designed to help analysts evaluate the credit risk of corporation for debt purposes. The Merton model provides objective measures for the company's ability to serve and repay debt obligations. It also serves as a scale of credit failure.

In order to approve loans, financial institutions must first determine the risk or probability of the company's default value. This helps the creditor to assess the company's ability to repay the loan. Credit failure is defined as any credit event that prevents companies from repaying principal or loan interest. The more financial institutions can predict the loan event, the better they will be in the fund compensation than it is too late.

Securities analysts use the Merton model as a way to predict trends in securities prices. The company in financial distress generally experiences a drop in stock price. If an analyst canThe Merton company can be able to benefit from this knowledge by selling shares before it falls or purchasing insurance against a specific credit event.

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functioning of the Merton is complex. The model evaluates credit risk based on the prices of options. The possibility gives the right, but not an obligation to sell or purchase a specific asset in the future. In the Merton model, the value of the company's asset can be used as a representative for the company's credit risk. Sure, the more investors buy insurance against the loss of the value of the company's assets, the higher the risk of credit failure.

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Merton model assumes that the company has sold zero coupon bonds to raise money. A bond that does not pay bond holders is called zero coupon bond every year because the coupon rate is zero. Instead of paying coupon rate each year is sold bond with zero couponEm for a deep discount. The investor returns when the bond is applied to the entire nominal value in the future.

If the company cannot repay the debt on zero coupon bonds, it is considered a credit event or default. According to the Merton model, the credit event occurs when the value of the company's assets is lower in the future than the value of bonds. This means that the company is in financial need, if the amount owed by bond holders is lower than the value of its assets. Empirical testing has shown that the Merton model is accurate for non -financial companies such as manufacturing or retail organizations. Unnecessarily, however, it has not been shown to be a good level of credit risk in banks because they are highly used entities.