Financial Simulation Modeling in Excel

THE THEORY BEHIND THE MERTON MODEL

The Merton Model was first developed by Robert Merton in 1974 and was the first of what are now called “structural models” of debt and default. Merton worked with Fisher Black and Myron Scholes to develop the Black-Scholes equation for option pricing, and the Merton Model is based on a similar understanding of price movements. The key point in understanding how structural models work is to consider the equity to be a contingent residual claim holder on the value of the assets of the firm. This is a complex idea that we will explain soon in more detail.

First, let us consider how companies default. In general, there are three types of ways that a company can default on its issued debt. One is that a company does not comply with the covenants it has agreed to in the loan documentation. This is sometimes referred to as a “technical default” because often a company will continue to pay its creditors, and the creditors may not take action against the debtor. From a quantitative point of view, while technical defaults may trigger certain legal repercussions or a renegotiation of terms, they are not considered economic defaults, and as a result they are not generally included in default analysis.

The other two general categories of defaults are generally considered “credit events,” which can impact all of a company's stakeholders. The first type of credit event is nonpayment, which occurs when a debtor does not pay principal or interest on an assigned ...