Improving Merton: an analysis of Merton’s original default risk model, its extensions, and potential areas of further improvement

Abstract

This paper examines the structural class of credit risk models, beginning with the original Merton (1974) model. Structural models provide the intuitive benefit of linking a firm’s likelihood of default to its underlying capital structure and other relevant, endogenous financial information, and are hence considered over reduced-form models of default risk in this paper. Following a clear presentation of the mathematics behind Merton’s original model, the strengths and weaknesses of the model are discussed. Next, a detailed look at the vast set of improvements and extensions to Merton over the past 40 years reveals a myriad of ways to overcome the limitations and flawed assumptions of Merton (1974). Some techniques are promoted in this paper over others. Then, after discussing ways to estimate unobservable yet crucial quantities like current asset value and asset volatility, a path to further extension and improvement of current structural models is suggested and described. Conclusions and suggestions for further research follow.