Credit Risk : Merton Model Limitations

627 words - 3 pages

Evaluate of the Merton Model for credit risk analysis

The KMV-Merton model proposed by Robert Merton(1974)is an application of classic option pricing theory and as a logical extension of the Black-Scholes(1973)option pricing framework.Merton’s approach assess the credit risk of a firm by characterizing the firm’s equity as a call option on the underling value of the firm with a strike price equal to the face value of the firm’s debt and a time-to-maturity of T.By put-call parity,the value of the firm’s debt is equal to the value of a risk-free discount bond minus the value of a put option written on the firm with a strike price equal to the face value of debt and a time-to-maturity of T.

To some extent,our calculated probability of default is reasonable.In fact,dynamics of default probability comes mostly from the dynamics of the equity values.KMV model can always quickly reflect deterioration in ...view middle of the document...

However there are also some weaknesses of this approach that may lead to the inappropriate probability of default.Our estimation of probability of default requires subjective estimation of the input parameters.We estimate volatility of equity from historical stock returns data and thus the market value and volatility of the firm’s asset,assuming one year forecasting horizon.Because only the price of equity for most public firms are observable,this model cannot be used by private firms.Instead,another model called RiskCalc can be applied by private firms which makes use of robust relationships between characteristics of private firms and the probability of default.The performance of Merton model in predicting default also depends on how realistic its assumptions are.It is difficult to construct theoretical default probability without the assumption of normality of asset returns and the too simplistic capital structure of the firm.(ie,value of firm=value of equity+value of debt)

In practice, we can only hope to estimate probabilities of default. That is, we will not be able to definitively classify firms into will default and will not default categories. As a result, in assessing the performance of a model, we face the task of assessing its ability to discriminate between different levels of default risk.As argued by Bharath and Shumway(2008),the probability of default implied by the Merton model is insufficient statistic for forecasting bankruptcy.They presented a “naive”application of Merton model that outperformed the complex application of Merton model.Also,The KMV model is static,meaning that once the debt is in place the firm does not change it. The default behavior of firms that manage their leverage positions is not captured.

Despite these limitations,the Merton model is being extensively used by Moody,S&P and other credit rating agencies worldwide for assessing the default probability of borrowing firms.This is because option-pricing models in bankruptcy prediction can provide guidance about the theoretical determinants of bankruptcy risk and necessary structure to extract bankruptcy-related information from market prices.

Other Papers Like Credit Risk : Merton Model Limitations

Merton Truck Company Case Essay

1741 words - 7 pages that Merton Truck Company adopt the suggest solutions in our analysis in order to achieve better financial results and impose new policies later on to avoid such setbacks in the future. Following our recommendations, the firm should be able to maximize the profits using the optimal product mix. Model Description The Problem Merton Truck Company is not optimizing contribution from its truck lines especially model 101. The company is

Merton Truck Company Essay

1517 words - 7 pages ), so this shows that this model is not losing money and thus its production shall not be stopped and model 102 truck has a contribution of $5000 per unit. Analysis: * Model 101 not losing money: contribution per unit for model 101 is $3000/truck and for model 102 is $5000/truck (refer attachments-calculations 1) * Product mix that maximizes contribution: The Linear analysis model shows that the contribution can be maximized if Merton

Effectiveness of Credit Risk Management on the Financial Performance of Philippine Universal Banks

1604 words - 7 pages . Earnings of Credit Facility (E) | | |5. Liquidity (L) | | |6.Bank Size(S) | | Fig. 1. Model of Determining Factors of Effectiveness of Credit Risk

Doc, Docx, Pdf, Wps, Rtf, Odt

5339 words - 22 pages –Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." A number of commentators have suggested that if the liquidity crisis continues, there could be an extended recession or worse. The continuing development of the crisis has prompted in some quarters

Cv for My Success

588 words - 3 pages head office improvement, Data Quality management, Regular risk reporting). Met National Supervisory in terms of IRB application status of the bank. (Rating model 06/2008 – 11/2008 EFG Eurobank AD, Bulgaria Credit risk management, Head of department  Managed a department of 9 risk managers,  Responsible for corporate and retail credit risk 08/2005 – 05/2008 Raiffeisenbank AD, Bulgaria Corporate credit risk, Risk manager/ Head of

Credit Risk

587 words - 3 pages Credit Risk Management: Credit risk can be defined as risk of failure of customer/counterparty of the bank to meet financial obligations. Another major source of credit risk could be concentration risk, which arises when a bank’s credit portfolio tend to be non-diversified i.e. large single borrower exposure or lending exposure to clients having similar economic factors (single sub-sector, industry, geographic region etc.) that would adversely

Risk Management In Banking

9309 words - 38 pages Capital Supervisory Market Requirements Review Process Discipline 2.2.1 THE FIRST PILLAR – MINIMUM CAPITAL REQUIREMENTS The first pillar sets out minimum capital requirement for the bank. The new framework maintains minimum capital requirement of 8% of risk assets. Basel II focuses on improvement in measurement of risks. The revised credit risk measurement methods are more elaborate than the current accord. It proposes for the

Įmonių Kredito Rizikos Vertinimo Modelių Analizė

2354 words - 10 pages reitingavimas: Lietuvos bankų patirtis. Pinigų studijos, 1, 2007. [11] Taraila S. Kreditavimas: teorija ir praktika. Vilnius: Lietuvos bankininkystės, draudimo ir finansų institutas, 2001 [12] Tarashev N.A. An empirical evaluation of structural credit risk model. BIS Working Papers No. 179, 2005. Peržiūrėta 2009, vasario 19, adresu: [13] Tom D. Credit Risk Analysis And Credit Scorin – Now And In

Credit Risk Analysis in Standard Charter Bank

562 words - 3 pages practice procedures to monitor and manage these risks and their impact on revenues. Relate these risks to bank capital. CONTENT I. ANALYTIC OVERVIEW Overview • Why risk management is critical to banks • Value drivers and business model of a bank. • Understanding differing perspectives: shareholders, regulators, and debt providers. Risk management • Major risk groups: credit, market, liquidity, operational. • Management objectives – risk versus

Blue Nile Inc Management Evaluation

565 words - 3 pages . ownership passes to the customer when it is received by the customer. In other countries is passes when the merchandise is shipped. Reduced revenue for returns are an estimated based on historical data and current economic conditions. Blue Nile accounts for stock-based compensation at fair value. They use the Black-Scholes-Merton option valuation model (mathematical model of a financial market containing certain derivative investment instruments

The Advantages and Disadvantages of Purchasing Commercial Credit Risk Insurance

1254 words - 6 pages The Advantages and Disadvantages of Purchasing Commercial Credit Risk Insurance One of the few tangible assets on the International Manufacturing Company Balance Sheet that is not insured is Accounts Receivable. One method of securing Receivables is by domestic and international credit insurance. A credit insurance policy is designed to protect a company's Accounts Receivable from catastrophic credit losses. Credit insurance may offer a

Related Essays

Accounting In Context Essay

5394 words - 22 pages and making decision a loan for customers, but it is better if the Bank could combine them and use at the same time because it could consider the customer in many sides and more flexible. In the Journal of Banking and Finance in January 2000, Jose A.Loper relied on some limitations of the credit risk model in general, such as without the market price as a factor in calculating, so the result would not present for the future. On the other hand, Gordy

Credit Risk Essay

1037 words - 5 pages Commercial Banking The first category of credit risk models are the ones based on the original framework developed by Merton (1974) using the principles of option pricing (Black and Scholes, 1973). * the default process of a company is driven by the value of the company’s assets and the risk of a firm’s default is therefore explicitly linked to the variability of the firm’s asset value. * The basic intuition behind the Merton model is

Frm Syllabus Essay

1406 words - 6 pages agencies, credit ratings 11. Credit transition matrices 12. Sovereign risk and country risk evaluation 13. Derivatives a. Options Pricing i. Numerical Methods (Binomial Tree, Monte-Carlo Simulation) ii. Analytical Models (Black-Scholes-Merton) b. Estimating Greeks 14. Limitations of VaR and Alternatives – Tail VaR / CVaR, Stress Testing, Scenario Analysis. PART II Market Risk Measurement and Management 1. Volatility Skews, Volatility

Consumer Credit Scheme And Its Risk Management Of Different Commercial Banks In Bangladesh: Implications For Ific Bank Limited Bangladesh

3244 words - 13 pages the probability of moving from one credit quality to another, including default, within a given time horizon. Second, the option pricing, or structural approach, as initiated by KMV and which is based on the asset value model originally proposed by Merton (Merton, R., 1974. Journal of Finance 28, 449-470). In this model the default process is endogenous, and relates to the capital structure of the firm. 3.0 METHODOLOGY 3.1 Research Design