Merton Model
Corporate Credit Analysis glossary · Credit Metrics & Debt Schedule Modeling
Definition
A structural model treating equity as a call option on the firm's assets; default occurs when asset value falls below debt at maturity. Foundation of distance-to-default and KMV/EDF approaches.
Merton Model in plain English
The Merton model is a clever way to figure out how likely a company is to go bust, and its big insight is to view owning stock in a company as basically holding a bet. Here's the idea: a company owns assets but also owes debt, and the shareholders only keep what's left after the debt is paid; if the assets end up worth less than the debt when the loan comes due, the owners get nothing and the company defaults. So being a shareholder is like having an option — a right to claim the leftover value only if there's leftover value — and the further the company's assets sit above its debt line, the safer it is (that cushion is called 'distance to default'). This framing powers famous credit tools like KMV/EDF that banks use to score default risk. In short: measure how much room there is before the assets sink below what's owed, and you've measured the danger.
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