Using Merton model for default prediction: An empirical assessment of selected alternatives

Abstract

It is surprising that although four decades passed since the publication of Merton (1974) model, and despite the development and publications of various extensions and alternative models, the original model is still used extensively by practitioners, and even academics, to assess credit risk. We empirically examine specification alternatives for Merton model and a selection of its variants, concluding that default prediction goodness is mainly sensitive to the choice of assets expected return and volatility. A Down-and–Out Option pricing model and a simple naive model outperform the most common variants of the Merton model, therefore we recommend using the simple model for its easy implementation.