Using Merton model: an empirical assessment of alternatives (Afik Z., Arad O., Galil K.)

Bank Lending Risk-taking and Risk Management

Abstract Merton (1974) suggested a structural model for default prediction which allows using timely information from the equity market. The literature describes several specifications to the application of the model, including methods presumably used by practitioners. However, recent studies demonstrate that these methods result in inferior estimates compared to simpler substitutes. We empirically examine various specification alternatives and find that the prediction goodness is only slightly sensitive to different choices of default barrier, whereas the choice of assets expected return and assets volatility is significant. Equity historical return and historical volatility produce underbiased estimates for assets expected return and assets volatility, especially for defaulting firms. Acknowledging these characteristics we suggest specifications that improve the model accuracy.
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Libref/ Afik Z., Arad O., Galil K. (2012) “Using Merton model: an empirical assessment of alternatives”, Discussion Paper No. 12-02.
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