Merton Model assumes that a company has a certain amount of zero - coupon debt that will become due at a future time T. It needs a number of assumptions regarding the firm value process and the risk free interest rate process to derive analytically the market value of risky debt and the associated probability that a firm will default on its debt. However, there are some limitations of the model.
Firstly, Merton Model is based on assumptions that in the event of default absolute priority hold, renegotiation is not permitted and liquidation of the firm is costless (Benos & Papanastasopoulos, 2005). These assumptions imply full recovery rates and default costs equal to zero. Therefore, the model should include the direct and indirect costs of financial charges such as lawyer fees, administration expenses. Also, the model should allow a fractional recovery when default occurs.
Secondly, the Merton model only assumes that a company will only default at its debt maturity date (Wang, 2009). The model can be modified to allow for early defaults by specifying a threshold level such that a default event occurs when asset value falls below a certain level.
Thirdly, it is not reliable of only using a constant risk - free rates, which cannot model the relation between interest rate risk, asset risk and default risk. According to Wang (2009), a stochastic interest rate model can be incorporated into Merton model. Random scenario models generate scenarios of future interest rates or yield curves by applying a random number generator to one or more probability distributions. Therefore, a full set of interest rates for future periods could be developed.
The Merton model bases on the theories about market efficiency, which indicate the equity price should reflect all relevant and available information about the firm’s fundamentals. However, the theoretical probabilities estimated from Merton Model do not capture all available information about the...