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The Use of the Merton Model to Quantify the Default Probabilities of the Top 42 Non-Financial South African Firms

Author

Listed:
  • Glen Holman
  • Ryan Van Breda
  • Carlos Correia

    () (University of Cape Town)

Abstract

The objective of this paper is to quantify the default probabilities of the top 42 nonfinancial firms listed on the Johannesburg Stock Exchange. This paper follows the same methodology as outlined in the Moody’s KMV white papers in implementing the Merton (1974) model. The model of default prediction builds upon option theory as pioneered by Black-Scholes-Merton and derives the probability of default predominately from asset value, asset volatility and a firm’s leverage. The theoretical default probabilities of the top 42 listed non-financial firms are determined under base-case and worst-case scenarios and South African companies are generally found to have singularly low probabilities of default. This mainly reflects the low use of financial leverage by South African firms. This paper finds that there is weak correlation between Merton default probabilities and ratings issued by the rating agencies. The results of this paper indicate that the Merton (1974) model may, subject to limitations, be used as a source of information of the underlying credit risk of publicly traded firms in South Africa.

Suggested Citation

  • Glen Holman & Ryan Van Breda & Carlos Correia, 2011. "The Use of the Merton Model to Quantify the Default Probabilities of the Top 42 Non-Financial South African Firms," The African Finance Journal, Africagrowth Institute, vol. 13(Conferenc), pages 1-33.
  • Handle: RePEc:afj:journl:v:13:y:2011:i:conference:p:1-33
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    Keywords

    Probability of default; Merton Model; Black-Scholes option pricing model; Distance to default; Moody's KMW; Ratings; Default point; Asset volatility;

    JEL classification:

    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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