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The Merton Model

The document summarizes key aspects of the Merton model for valuing corporate debt and equity. It describes: 1) How corporate debt and equity payoffs are contingent claims on the value of the firm's assets, similar to short/long positions in puts/calls; 2) How to calculate the expected present value of debt and equity by taking the risk-neutral expectation of their payoffs; 3) How the credit spread is the difference between the debt yield and risk-free rate.

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Brian Jeppesen
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72 views12 pages

The Merton Model

The document summarizes key aspects of the Merton model for valuing corporate debt and equity. It describes: 1) How corporate debt and equity payoffs are contingent claims on the value of the firm's assets, similar to short/long positions in puts/calls; 2) How to calculate the expected present value of debt and equity by taking the risk-neutral expectation of their payoffs; 3) How the credit spread is the difference between the debt yield and risk-free rate.

Uploaded by

Brian Jeppesen
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Brian Jeppesen Merton Model 1/ 12

The Merton model



Payoff to the debt and equity

Expected present value of the debt and equity

Spread

Some problems and possible extensions

Questions


(Assumptions)

(Default probability)

(Implied volatility)

Brian Jeppesen Merton Model 2/ 12

Payoff to the equity


A company has assets with a value of V .

The company has a certain amount of zero coupon debt D due at time t .

The value of the equity S at maturity is the residual value:

0
t t
t
t
V D if V D
S
if V D
>
=


Payoff diagram:



Thus, the equity has the same appearance as a European call option: ( ) max ; 0
t t
S V D = .



0 50 100
0
20
40
60
Value of equity at maturity
V
S
t

Brian Jeppesen Merton Model 3/ 12

Payoff to the debt

The debt is a contingent claim on the assets:

t
t
t t
D if V D
B
V D if V D
>
=



Payoff diagram:



Thus, the debt has the same appearance as portfolio of a short put plus the debt: ( ) max ; 0
t t
B D D V =




0 50 100
0
20
40
60
Value of debt at maturity
V
B
t

Brian Jeppesen Merton Model 4/ 12

Expected present value of the equity

The expected present value of the equity is:
( )
t
S E PV S = (


The asset value is stochastic:
( )
t
V f v

where v is an observed value of the asset.


Thus, the expected value is found by integration:

( ) ( )
( ) | | ( )
max ; 0 dv
|
rt
rt Q Q
t t t
S e v D f v
e P V D E V V D D

=
= < <



where Q represents the risk neutral probability measure.
Brian Jeppesen Merton Model 5/ 12

Expected present value of the equity (II)

A geometric Brownian motion in continuous time under the risk neutral probability measure:
dV rVdt VdW = +

Solution for a geometric Brownian motion:

( ) ( ) ( )
1 2
, , , , N N
BS rT
S C V D r t V d De d

= =

where
( )
2
1
ln / 0.5 / d V D r t t
(
= + +

and
2 1
d d t = .

Payoff diagram:

0 50 100
0
20
40
60
Value of equity
V
S
0

Brian Jeppesen Merton Model 6/ 12

Expected present value of the debt
The expected present value of the debt is:
( )
t
B E PV B = (


Solution for a geometric Brownian motion:
( )
rT
B De P D

=

A long call Cand a short P is equal to the value of a forward contract F:
( ) ( ) ( )
rT
C D P D F D V De

= =
Using this put-call parity:
( ) B V C D V S = =
Payoff diagram:


0 50 100
0
20
40
60
Value of debt
V
B
0

Brian Jeppesen Merton Model 7/ 12

Spread

The expected present value of the debt in terms of the yield y is:
yT
B e D

=

Thus, the spread is:
1
ln
D
s y r r
t B
= =
Spread diagram:

It is positive and at 0 t = it goes to zero.


0 20 40
0
0.005
0.01
0.015
0.02
t
s

=

y

-

r
Spread, D=70
V = 90
V = 130
V = 180
Brian Jeppesen Merton Model 8/ 12

Some problems and possible extensions

Spread for short terms is too low Poisson process.

Do we know the distribution for the asset value implied volatility from stock price (Itos lemma).

The interest rate is stochastic double integration.

Sometimes there is a recovery payoff can be a step function.

Is the debt a contingent claim perpetual claim instead.

What about coupons iterative procedure.

What about different levels of seniorities.

Brian Jeppesen Merton Model 9/ 12

Questions

Brian Jeppesen Merton Model 10/ 12

Some constraints/assumptions for the most basic version

Debt and equity are underlying the asset value.

Agents are price takers.

Short selling allowed.

No transaction cost.

Borrow and lend at a fixed risk free rate.

Geometric Brownian motion.

Debt expires at maturity.

No coupons payments.

Brian Jeppesen Merton Model 11/ 12

Default probability in the Merton model

The company defaults if the value of the assets at maturity is less than the debt.

Default probability:
( ) ( )
( ) ( )
2
2
ln
0 ln0
ln / 0.5
ln 0.5 1 1
d exp dv
2 2
D D
T
D V t
v V t
P V D f v v
t t t



| | | |

| |
| | < = = =
|
| |
\ .
\ . \ .


The distance to default is:
( )
( ) ( )
2
ln 1 0.5
T
DD t
V D
DD P V D
V t


| |

| = < =
|
\ .

Graphical illustration:


0
0.5
1
1.5
2
0
0.05
0.1
0
0.2
0.4
0.6
DD
Default probability (T = 1)

P
(
V
<
D
)
=0.25
=0.4
Brian Jeppesen Merton Model 12/ 12

Implied volatility

The value of the equity is:
( )
BS
S C V =

We use the transformation:
( )
BS
Z C V =
The stochastic term in Itos lemma is:
dZ
dW
dV
V
Thus, the volatility of the equity is:
dZ
dV
S
V
S
=
The derivative equals:
( )
2
ln / 0.5
dZ
dV
V D r t
T

| |
+ +
| = =
|
\ .

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