Merton Model

Categories: Accounting, Credit

In order for financial institutions to stay in business, they must have business savvy...like making sure they’re not taking on too much risk. If too many borrowers don’t pay banks back for their loans, or if too many people cash out on their insurance, then these banks and insurance companies could become insolvent.

The Merton model is a credit risk model based on ye olde Black Scholes option pricing model. Economist Robert C. Merton saw a likeness in the option pricing model and financial institutions taking on structural credit risk. Merton treated a company’s equity as a call option on its current assets...to come up with the sheer-genius Merton model.

Anyone who wants to analyze a company’s risk of credit default can use the Merton model. You don't need a license for special, Bloombergian software.

Fun fact: the Merton model was the precursor to the Nobel Prize-winning Black-Scholes pricing model.

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