Financial Simulation Modeling in Excel

SHORT-TERM AND LONG-TERM LIABILITIES: THE BARRIER AND CALIBRATION

One of the key questions with setting up the Merton model, or any structural model, is where the point of default, or “knock-out,” occurs. Conceptually, the model is set up on the belief that once the value of the company's assets drops far below the amount of debt that needs to be repaid, the company will default on its debt as continued operation is unlikely to have value to the equity holders. The “barrier” level can be set in any number of ways, but the goal in setting a barrier level is to calibrate the model to the observed market.

In Merton's initial paper, he set the barrier to 100 percent of a company's short-term liabilities (due in a year or less) plus 50 percent of a company's long-term liabilities (due in a year or more). The reasoning behind this was that the management and equity of a company, as holders of an option on the assets of the firm, would tolerate the value of a firm's assets being below the level of liabilities to a certain extent. In these cases where the equity is “out of the money” or “under water,” the equity still can have substantial option value, especially in volatile or highly leveraged industries.

Given Merton's influence on the world of quantitative finance, there have been many papers published in peer-reviewed journals discussing the correct calibration of the model to observed defaults. Some of these papers segregate companies by industry and others separate them by the term ...