The Merton model, which is named after Robert C. Merton, was developed in the 1970s. It was designed to help analysts evaluate the credit risk of a corporation for debt purposes. The Merton model provides an objective measure for a company's ability to service and pay back debt obligations. It also serves as a measure of credit default.
In order to approve loans, financial institutions must first determine a company's risk or probability of default. This helps the lender to gauge the company's ability to pay back the loan. A credit default is defined as any credit event which prevents the company from paying back the principal or interest on a loan. The more financial institutions can forecast a credit event, the better they will be at recouping funds before it's too late.
Securities analysts use the Merton model as a way to forecast trends in security prices. In general, a company in financial distress will experience a drop in share price. If an analyst can determine the credit health of a company using the Merton model, they may be able to profit from that knowledge by selling the stock before it goes down or buying insurance against a particular credit event.
The workings of the Merton model are complex. The model assesses credit risk based on a company's option prices. An option gives the right, but not the obligation, to sell or purchase a particular asset in the future. In the Merton model, the value of the option to sell the firm's assets can be used as a proxy for the firm's credit risk. Put plainly, the more investors buy insurance against the loss in value of a company's assets, the higher the risk of credit default.
The Merton Model assumes that a company has sold zero coupon bonds in order to raise money. A bond that does not pay bondholders a fixed rate of interest every year is called a zero coupon bond because the coupon rate is zero. Instead of paying a coupon rate every year, a zero coupon bond is sold at a deep discount. The investor makes a return when the bond is redeemed for the full face value in the future.
If a company can't pay back the debt on the zero coupon bonds, it is considered a credit event or default. According to the Merton Model, a credit event occurs when the value of a company's assets are worth less than the value of the bonds in the future. That is, a company is in financial distress if the amount it owes to bondholders is less than the value of its assets. In empirical testing, the Merton model has been shown to be accurate for non-financial firms such as manufacturing or retail organizations. It has not, however, proven to be a good measure for credit risk in banks as they are highly leveraged entities.