10/31/2019 Merton Model Definition

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Merton Model Definition

REVIEWED BY WILL KENTON | Updated Jun 24, 2019

What Is the Merton Model?

The Merton model is an analysis model used to assess the credit risk of a company's debt.
Analysts and investors utilize the Merton model to understand how capable a company is at
meeting financial obligations, servicing its debt, and weighing the general possibility that it
will go into credit default.

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In 1974, economist Robert C. Merton proposed this model for assessing the structural credit
risk of a company by modeling the company's equity as a call option on its assets. This
model was later extended by Fischer Black and Myron Scholes to develop the Nobel-prize
winning Black-Scholes pricing model for options.

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The Formula for the Merton Model Is

E = Vt N (d1 ) − Ke−rΔT N (d2 )
where:
+ (r + ) ΔT
Vt σv2
ln K 2
d1 =
σv ΔT
and
d2 = d1 − σv Δt
E = Theoretical value of a company’s equity
Vt = Value of the company’s assets in period t
K = Value of the company’s debt
t = Current time period
T = Future time period
r = Risk-free interest rate
N = Cumulative standard normal distribution
e = Exponential term (i.e. 2.7183...)
σ = Standard deviation of stock returns

Consider a company's shares sell for $210.59, stock price volatility is 14.04%, the interest rate
is 0.2175%, the strike price is $205, and the expiration time is four days. With the given
values, the theoretical call option value produced by the model is -8.13.

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What Does the Merton Model Tell You?

Loan officers and stocks analysts utilize the Merton model to analyze a corporation's risk of
credit default. This model allows for easier valuation of the company and also helps analysts
determine if the company will be able to retain solvency by analyzing maturity dates and
debt totals.

The Merton (or Black-Scholes) model calculates theoretical pricing of European put and call
options without considering dividends paid out during the life of the option. The model can,
however, be adapted to consider these dividends by calculating the ex-dividend date value
of underlying stocks.

The Merton Model makes the following basic assumptions:

All options are European and are exercised only at the time of expiration.
No dividends are paid out.
Market movements are unpredictable (efficient markets).
No commissions are included.
Underlying stocks' volatility and risk-free rates are constant.
Returns on underlying stocks are regularly distributed.

Variables that were taken into consideration in the formula include options strike prices,
present underlying prices, risk-free interest rates, and the amount of time before expiration.

KEY TAKEAWAYS
In 1974, Robert Merton proposed a model for assessing the credit risk of a company
by modeling the company's equity as a call option on its assets.
This method allows for the use of the Black-Scholes-Merton option pricing model.
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The Merton model provides a structural relationship between the default risk and
the assets of a company.

The Black-Scholes Model Versus the Merton Model

Robert C. Merton was a famed American economist and Nobel Memorial Prize laureate, who
befittingly purchased his first stock at age 10. Later, he earned a Bachelor in Science at
Columbia University, a Masters of Science at California Institute of Technology (Cal Tech),
and a doctorate in economics at Massachusetts Institute of Technology (MIT), where he later
become a professor until 1988. At MIT, he developed and published groundbreaking and
precedent-setting ideas to be utilized in the financial world.

Black and Scholes, during Merton’s time at MIT, developed a critical insight that by hedging
an option, systematic risk is removed. Merton then developed a derivative showing that
hedging an option would remove all risk. In their 1973 paper, "The Pricing of Options and
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Corporate Liabilities," Black and Scholes included Merton's report, which explained the
derivative of the formula. Merton later changed the name of the formula to the Black-
Scholes model.

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Related Terms
How the Black Scholes Price Model Works
The Black Scholes model is a model of price variation over time of financial instruments such as
stocks that can, among other things, be used to determine the price of a European call option. more

Heston Model Definition

The Heston Model, named after Steve Heston, is a type of stochastic volatility model used by financial
professionals to price European options. more

T-Test Definition
A t-test is a type of inferential statistic used to determine if there is a significant difference between
the means of two groups, which may be related in certain features. more
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Monte Carlo Simulation

Monte Carlo simulations are used to model the probability of different outcomes in a process that
cannot easily be predicted due to the intervention of random variables. more

How the Residual Standard Deviation Works

The residual standard deviation is a statistical term used to describe the difference in standard
deviations of observed values versus predicted values as shown by points in a regression analysis.
more

Understanding Moving Averages (MA)

A moving average is a technical analysis indicator that helps smooth out price action by filtering out
the “noise” from random price fluctuations. more

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