3. Measurement of Probability of Default from Equity Prices

3. Merton Model

1. The Theory of Merton Model

The Merton model, based on Black-Scholes-Merton option pricing theory, evaluates various components of firm value.

The simplest assumption of the model:

• The existence of a non-dividend paying firm with only one liability claim.
• The financial markets are perfect.

Suppose that the firm’s only debt issue is a zero-coupon bond with a face value (or principal amount) of $F$, due at the maturity date of $T$.

• If the firm is unable to pay the principal at $T$, then the firm is bankrupt and the equity claimants receive nothing.
• If the firm value at $T$, $V_T$, is large enough to pay the principal amount, then equity holders have claim to the balance, $V_T-F$.

These two payoff possibilities are the same as the payoffs for a call option, with the firm value as the underlying asset and the principal amount as the exercise price.
Therefore, the value of equity at $T$ is $E_T=\text{Max}(V_T-F,0)$

• If the firm value $V_T$ is less than the $F$, the amount received by the debtholder will reduced by $F-V_T$.
• If the firm value $V_T$ is less than the $F$, the debtholder will receive the principal amount at the maturity for the zero-coupon bond, which is $F$.

These two payoff possibilities are the same as a Treasury bill with a face value of $F$ and selling a put on the firm value with an exercise price of $F$.
Therefore, the value of debt at $T$ is $D_T=F-\text{Max}(F-V_T,0)$

The value of the debt plus the value of equity must be equal to the total value of the firm.

$V_T=D_T+E_T\to D_T=V_T-E_T\to D_T=V_T-\text{Max}(V_T-F,0)$

Therefore, the value of debt is also the difference between the value of the firm and the call option on the value of the firm with $F$ as the exercise price.

The Black-Scholes-Merton option-pricing model for European options can be modified to determine the value of equity prior to $T$, $T-t$, if additional assumptions are made, which include:

• Firm value characterized by a lognormal distribution with constant volatility, $\sigma$.
• Constant interest rate, $r$.
• Perfect financial market with continuous trading.

2. The Formula of Morton Model

2.1 The Value of Equity/Debt at Time $t$

Using arbitrage pricing for a portfolio of securities that replicates the value of the firm results in Merton’s formula for the value of equity:

$E_t=VN(d_1)-F{e}^{-r(T-t)}N(d_2)$

There are two methods for valuing risky debt in this framework. Risky debt is equal to:

Risk-free debt minus a put option on the firm
$D_t=F{e}^{-r(T-t)}-[F{e}^{-r(T-t)}N(-d_2)-VN(-d_1)]=F{e}^{-r(T-t)}N(d_2)+VN(-d_1)$

Firm value minus equity value
$D_t=V-E_t=F{e}^{-r(T-t)}N(d_2)+VN(-d_1)$

• $d_1=\frac{In\left(\frac{V}{F{e}^{-r(T-t)}}\right)}{\sigma \sqrt{T-t}}+\frac{\sigma \sqrt{T-t}}{2}=\frac{In(V/F)+(r+{\sigma }^2/2)(T-t)}{\sigma \sqrt{T-t}}$
• $d_2=d_1-\sigma \sqrt{T-t}$
• $V=$ value of the firm
• $F=$ face value of the firm’s zero-coupon debt maturing at $T$ (only liability)
• $\sigma =$ volatility of the value of the firm
• $r=$ annual interest rate
• $N(d)=$ cumulative normal distribution function evaluated at $d$

The following table shows the general relationships between debt and equity values according to the inputs of the Merton Model.

	Value of Firm, $V$	Face Value of Debt, $F$	Time to Maturity, $T$	Interest Rate, $r$	Volatility of Firm Value, $\sigma$
Value of Debt	$+$	$+$	$-$	$-$	$-$
Value of Equity	$+$	$-$	$+$	$+$	$+$

2.2 Firm Value and Volatility

we assume that small changes in the return on equity are perfectly correlated with the value of the firm. A small change in firm value will change the value of equity by delta, $\Delta$, times the change in firm value.

Delta is the rate of change in the value of the call option relative to the change in the value of the underlying asset, $\Delta E/\Delta V$. The Merton model delta, ∆, is equal to $N(d_1)$.

Therefore, if we know the parameters for calculating the value of equity as a call and the value of risk-free debt, then we can determine the firm’s value and the volatility of firm value.

$$\{\begin{array}{l}{E}_t=VN(d_1)-F{e}^{-r(T-t)}N(d_2)\\ {\Delta }_E\times E=\text{Delta}\times {\sigma }_V\times V\end{array}\to \{\begin{array}{l}{V}_t\\ {\sigma }_V\end{array}$$

Although delta is increasing as the value of the firm increases, the change in the value of equity decreases as firm value increases. This indicates that the distribution of equity values is not constant (which is sometimes referred to as a volatility smirk). The non-constant volatility of equity is a violation of the Black-Scholes-Merton model.

2.3 Using the Merton Model to Calculate PD and LGD

The Merton model for probability of default (PD) and loss given default (LGD) assumes that firm value is lognormally distributed with a constant volatility, and that the firm only has one liability, which is zero-coupon debt issue. The model also requires the expected return on the value of the firm $\mu$.

$N(d_2)$ is the risk-neutral probability of exercising, or that the bond will not default. Therefore, $N(-d_2)$ is the risk-neutral probability of default.

The Merton Model for $\text{PD}$:

$\text{PD}=N\left(\frac{In(F/V)+({\sigma }^2/2-\mu )(T-t)}{\sigma \sqrt{T-t}}\right)$

The Merton Model for $\text{LGD}$:

$\text{LGD}=F\times \text{PD}-V{e}^{\mu (T-t)}\times N\left(\frac{In(F/V)-({\sigma }^2/2+\mu )(T-t)}{\sigma \sqrt{T-t}}\right)$

The simplest case for calculating probability of default assumes that the process for default is not correlated with the interest rate process or the recovery rate.

The recovery rate is a fixed proportion of the principal that the debtholder receives in the event of default. The recovery rate is not dependent on time.

To find the value of debt, the probability of default and the recovery rate are required. If the debt is publicly traded, then the probability of default and the recovery rate can be estimated from the current price of debt; however, most debt instruments are not publicly traded.

In addition to the lack of public trading, there are four differences in measuring the risk of a debt portfolio that make estimating the probability of default and the loss due to default more challenging:

• If securities are illiquid, then the historical data is not reliable.
• The distribution of bond returns is not normal because the debtholder cannot receive more than the face amount plus the sum of the coupons.
• Debt is issued by creditors who do not have traded equity.
• Debt is not marked to market in contrast to traded securities. That is, a loss is recognized only if default occurs.

The following table shows the relationships between the inputs of the Merton model and the probability of default and then compares each relationship to loss given default.

	Value of Firm, $V$	Face Value of Debt, $F$	Time to Maturity, $T$	Expected Return, $\mu$	Volatility of Firm Value, $\sigma$
$\text{PD}$	$-$	$+$	$-$	$-$	$+$
$\text{LGD}$	$-$	$-$	$-$	$-$	$+$

2.4 Distance to Default

In the preceding equation, the components that lie within the brackets are seen as a standardized measure of the “distance to the debt barrier.” This distance represents a threshold beyond which a firm will enter into financial distress and subsequently default.

The Merton Model(assuming $T-t=1$) for distance to default ($\text{DtD}$):

$\text{DtD}=d_2=\frac{In(V/F)+(\mu -{\sigma }^2/2)(T-t)}{\sigma \sqrt{T-t}}\approx \frac{In(V/F)}{\sigma }$

2.5 Credit Spread

A credit spread is the difference between the yield on a risky bond (e.g, corporate bond) and the yield on a risk-free bond (e.g, T-bond) given that the two instruments have the same maturity,

The credit spread can be calculated using the following formula:

$\text{Credit Spread}=-\frac{1}{T-t}\times In\left(\frac{D}{F}\right)-r_f$

For a given risky bond, the most you can receive is the par value at maturity. However, as time increases there is greater probability that the value received will be less than par. Studies have shown that as time to maturity increases, credit spreads tend to widen (i.e., increase). This applies to both high-rated and low-rated debt. However, for very risky debt, it may be the case that credit spreads narrow since there is a greater chance of payment as maturity approaches.

In addition to time to maturity, interest rates can also impact credit spreads. As the risk-free rate increases, the expected value of the firm at maturity increases, which in turn decreases the risk of default. A reduction in the risk of default will narrow (i.e., decrease) credit spreads.

2.6 Subordinate Debt

In the event of bankruptcy, subordinated debt will receive payment only after all obligations to senior debt have been paid. Because of the uncertainty associated with inancial distress, the value of subordinated debt acts more like an equity security than a debt security. Therefore, when a firm is in financial distress, the value of subordinated debt will increase as firm volatility increases, while the value of senior debt will decline.

Suppose a firm has one issue of subordinated debt ($\text{SD}$) and one issue of senior debt ($D$) where both issues have the same maturity date, $T$. $F$ and $U$ represent the face values of senior debt and subordinated debt, respectively. Equity, $E$, is valued as a call option on the value of the firm, $V$, with an exercise price of $F+U$.

Subordinated debt can be valued in a portfolio as a long position in a call option on the firm with an exercise price equal to the face value of senior debt, $F$, and a short position on a call option on the firm with an exercise price equal to the total principal due on all debt, $U+F$.

The following table shows the relationships for capital components for low firm values. In the poor financial condition, the subordinate debt is more like an equity claim.

Variable	Time to Maturity, $T$	Volatility of Firm Value, $\sigma$	Annual Interest Rate, $r$
Senior debt	$-$	$-$	$-$
Subordinated debt	$+$	$+$	$+$
Equity	$+$	$+$	$+$

The following table shows the relationships for capital components for high firm values. In the good financial condition, the subprdinate debt is more like a senior debt.

Variable	Time to Maturity, $T$	Volatility of Firm Value, $\sigma$	Annual Interest Rate, $r$
Senior debt	$-$	$-$	$-$
Subordinated debt	$-$	$-$	$-$
Equity	$+$	$+$	$+$

3. Morton’s Model Advantages and Limitations

Advantages

• Morton’s Model relies on the prices of equities which are more actively traded than bonds.
• Correlations between equity prices can generate correlations between defaults, which are otherwise difficult to measure.
• Morton’s Model generates movements in PD that seem to lead changes in credit ratings.

Limitations

• Morton’s Model is applicable only to liquid, publicly traded names.
• Morton’s Model relies on a static model of the firm’s capital and risk structure. There is a continuous need for calibration.
• Morton’s Model has great sensitivity of results to parameters and input measures.
• Morton’s Model fail to fully reflect the dependence of credit risk on the business and credit cycles.
• Morton’s Model cannot be used to price sovereign credit risk.
• Morton’s Model falls short of explaining spreads like interest rate risk.

4. KMV Model

KMV model is built on the Merton model and tries to adjust for some of the shortcomings:

• In Merton model, all the debt matures at the same time, while in KMV model, it contains short-term debt and long-term debt.
• In Merton model, the value of the firm follows a lognormal diffusion process, while in KMV model, it has no assumption of asset value distribution.