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Using Merton model: an empirical assessment of alternatives

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  • Zvika Afik

    ()
    (Guilford Glazer faculty of Business and Management, Ben- Gurion University of the Negev, Israel)

  • Ohad Arad

    ()
    (Ben Gurion University of the Negev, Beer-Sheva, Israel)

  • Koresh Galil

    ()
    (Ben Gurion University of the Negev, Beer-Sheva, Israel)

Abstract

Merton (1974) suggested a structural model for default prediction which allows using timely information from the equity market. The literature describes several specifications to the application of the model, including methods presumably used by practitioners. However, recent studies demonstrate that these methods result in inferior estimates compared to simpler substitutes. We empirically examine various specification alternatives and find that the prediction goodness is only slightly sensitive to different choices of default barrier, whereas the choice of assets expected return and assets volatility is significant. Equity historical return and historical volatility produce underbiased estimates for assets expected return and assets volatility, especially for defaulting firms. Acknowledging these characteristics we suggest specifications that improve the model accuracy.

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Bibliographic Info

Paper provided by Ben-Gurion University of the Negev, Department of Economics in its series Working Papers with number 1202.

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Length: 46
Date of creation: 2012
Date of revision:
Handle: RePEc:bgu:wpaper:1202

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Keywords: Credit risk; Default prediction; Merton model; Bankruptcy prediction; Default barrier; Assets volatility;

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  1. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
  2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
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Cited by:
  1. Charitou, Andreas & Dionysiou, Dionysia & Lambertides, Neophytos & Trigeorgis, Lenos, 2013. "Alternative bankruptcy prediction models using option-pricing theory," Journal of Banking & Finance, Elsevier, vol. 37(7), pages 2329-2341.

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