Predicting the credit risk through Merton model

Abstract

The paper gives an overview of current conceptual framework for the credit risk assessment dedicated to banks. The framework utilises the Merton model to estimate the default probabilities of companies that are supposed to be the main borrowers causing a formation of a greater credit risk in banks. By doing this, banks are able to reaffirm the ability of their borrowers in meeting loans commitments. Conceivably, it can facilitate the banking decision-making process and next complementing the existing instruments of credit risk mitigation. In the meantime, the paper compares the changes of values exist in company's asset and its volatility, company's drift rate and company's default probability if iterative procedure is applied in the framework. It is found that the values change in each variable is negligibly small to give much effect in predicting the credit risk. An example of Petra Perdana Berhad was done for the framework application.