Abstract
Merton (1974) suggested a structural model for defa ult prediction which allows using timely information from the equity market. Application of this model is not straightforward and several alternatives exist in the specification of the mode l. Academic literature has adopted methods presumably used by practitioners. However, recent s tudies discovered that these methods result in inferior estimates. We empirically examine various specification alternatives and discover that the goodness of prediction is only slightly sensitive t o different choices of default barrier. The choice of assets expected return and assets volatility appear s to be crucial. Equity historical return and histo rical volatility produce underbiased estimates for assets expected return and assets volatility especially f or defaulting firms. Acknowledging these problems we suggest specifications that improve the model’s accuracy.
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