The Merton Model

A Structural Approach to Default Prediction

Agenda

 Idea

 Merton Model

 The iterative approach

 Example: Enron

 A solution using equity values and equity volatility

 Example: Enron

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Idea
 Consider the following company

 Following identity holds:

Asset value = Value of equity + Value of liabilities

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 Consider the following scenario:

 Requirements to determine the PD:

 firm‘s liability from balance sheet
 specify the probability distribution of the asset value at T

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 Common assumption: log asset value in T
follows normal distribution
 Besides, Merton assumes that follows a geometric
Brownian motion, i.e.

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 Conclusion: we can determine the PD if we know

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Merton Model
 Problem: we can‘t observe
 Solution: use of option pricing theory

 Consider a publicly traded company as before

 Payoffs at time T:

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 If no dividends are paid, use the

Black-Scholes call option formula

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Implementation of the Merton Model

 Assumption: maturity T = one year

 Two different approaches:

 Iterative approach (1)

 Solution using equity values

and equity volatilities (2)

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The iterative approach (1)

 Rearranging the Black-Scholes formula, we get

 Going back in time for 260 trading days, we get a

system of 261 equations in 261 unknowns

 σ can be estimated from a time series of V‘s

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 System of equations can be solved with
an iterative procedure:
Iteration 0: Set starting values for each
a = 0,1,…,260 and σ to the standard
deviation of the log asset returns.

 For any further iteration k = 1,…,end:

Insert the V‘s and σ into the formula for
and d , use Black-Scholes to compute d1 new V‘s
2

and compute a new σ.

 Go on until procedure converges

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Example: Enron
 Default in December 2001

 Biggest corporate default ever

 Implementation three months before its default

 Collect quarterly data on its liabilities from the SEC Edgar data
base

 One-year US treasury serves as the risk-free rate of return

 Can obtain market value of equity from various data providers

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Deriving an estimate of the drift rate

of asset returns using CAPM

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Implied default probability

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A solution using equity values

and equity volatilities (2)

 Use

for the current date t only

 Introduce another equation

 We have two equations with two unknowns

 use numerical routine to solve it

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 Now we can solve the system of equations

 Need feasible initial values (i.e. > 0) for the two
unknown variables
 Good choice:

with assumption

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 Why does this assumption make sense?
 In general:
 Compare the two definitions

 It holds

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Example: Enron

 Use same data and assumptions

 In addition: estimate of the equity volatility

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Solving the equation system

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Implied default probability

 Again we need the drift rate of assets

 Use CAPM as before

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Comparing different approaches

 Key results

 Question: Why do the PDs differ that much if we

have used the same one-year history of equity
prices?

 Answer: The iterative approach models changes in

leverage, the other one not!

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 Recall that we estimated  E from history of
 equity prices
 good way IF we think it is constant
 But equity risk varies if the asset-to-equity ratio varies
 equity risk varies with leverage

 Conclusion: For data characterised by large changes

in leverage one prefers the iterative approach

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Thank you for your attention

Thomas.Goswin@Bundesbank.de

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