Abstract
This paper presents a robust test of Merton's structural model for credit risk that does not depend on either estimated parameters for the firm's value or estimated default probabilities. We derive a test for the consistency of the changes in observed debt and equity prices (positive or negative changes) with the Merton model. For all firms selected and for all debt issues examined, the evidence strongly rejects Merton's structural model. employed to manage credit risk in banks and bond portfolios. Merton's model invokes the arbitrage free pricing methodology in friction- less and competitive markets. The key characteristic of Merton's model is that the underlying state variable that determines a firm's default is the value of its assets. Default free interest rates are assumed to be constant. Given a specific balance sheet for the firm (a fixed and static structure), at the maturity date of its short-term debt (a discount bond), if the firm's value falls below the face value of the short-term debt, then default occurs. In the event of default, the payoffs to the firm's liabilities follow absolute priority (written into the debt's covenants). Under this structure, the firm's equity is analogous to a call option on the firm's assets. As is well known, Merton's model has four empirical difficulties that make its implementation problematic:
Published Version
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