# Documentation

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## Default Probability by Using the Merton Model for Structural Credit Risk

In 1974, Robert Merton proposed a model for assessing the structural credit risk of a company by modeling the company's equity as a call option on its assets. This method allows for the use of the Black-Scholes-Merton option pricing methods. The Merton model is structural because it provides a relationship between the default risk and the asset (capital) structure of the firm.

From an accounting standpoint, the book value of a firm's equity, E, total assets, A, and total liabilities, L, are defined by the equation:

These book values for are E, A, and L are all observable because they are recorded on a balance sheet. However, the book values are reported infrequently. On the other hand, only the equity’s market value is observable, given by the firm’s stock market price times the number of outstanding shares. The market value of the firm’s assets and total liabilities are unobservable.

Merton’s model relates the market value of assets, equity, and liabilities in an option pricing framework. The Merton model assumes a single liability L with maturity T, usually within one year. At time T, the firm’s value to the shareholders equals the difference AL when the assets value A is greater than the liabilities L. However, if the debt L exceeds the asset value A, then the shareholders get nothing. The value of the equity ET at time T is related to the value of the assets and liabilities by the following formula:

In practice, firms have multiple maturities for their liabilities, so for a selected maturity T, a liability threshold L is chosen based on the whole liability structure of the firm. The liability threshold is also referred to as the default point. For a typical time horizon of one year, the liability threshold is commonly set somewhere between the value of the short-term liabilities and the value of the total liabilities.

Assuming a lognormal distribution for the asset returns, you can use the Black-Scholes-Merton equations to relate the observable market value of equity E, and the unobservable market value of assets A at any time prior to the maturity T:

where r is the risk-free interest rate, N is the cumulative standard normal distribution, and d1 and d2 are given by

${d}_{1}=\frac{\mathrm{ln}\left(\frac{A}{L}\right)+\left(r+0.5{\sigma }_{A}^{2}\right)T}{{\sigma }_{A}\sqrt{T}}$

${d}_{2}={d}_{1}-{\sigma }_{A}\sqrt{T}$

You can solve equation using two approaches:

• The mertonmodel approach, a single point calibration that requires equity, liability, and equity volatility (σE).

This approach solves for (AA) using a 2-by-2 system of nonlinear equations. The first equation is the preceding option pricing formula. The second equation relates the unobservable volatility of assets σA to the given equity volatility σE through the equation

${\sigma }_{E}=\frac{A}{E}N\left({d}_{1}\right){\sigma }_{A}$

• The mertonByTimeSeries approach, which requires a time series for the equity and for all other model parameters.

If the equity time series has n data points, this approach calibrates a time series of n asset values A1,…,An that solve the following system of equations:

$\begin{array}{l}{E}_{1}={A}_{1}N\left({d}_{1}\right)-{L}_{1}{e}^{-{r}_{1}{T}_{1}}N\left({d}_{2}\right)\\ ...\\ {E}_{n}={A}_{n}N\left({d}_{1}\right)-{L}_{n}{e}^{-{r}_{n}{T}_{n}}N\left({d}_{2}\right)\end{array}$

The volatility of assets σA is directly computed from the time series A1,…,An as the annualized standard deviation of the log returns. This value is a single volatility value that captures the volatility of the assets during the time period spanned by the time series.

Once the values of A and σA are known, the distance to default (DD) is computed as the number of standard deviations between the expected asset value at maturity T and the liability threshold:

$DD=\frac{\mathrm{log}A+\left({\mu }_{A}-{\sigma }_{A}^{2}/2\right)T-\mathrm{log}\left(L\right)}{{\sigma }_{A}\sqrt{T}}$

The drift parameter μA is the expected return for the assets, which can be equal to the risk-free interest rate, or any other value based on expectations for that firm.

The probability of default (PD) is defined as the probability that the asset value falls below the liability threshold at the end of the time horizon T:

$PD=1-N\left(DD\right)$