The Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing the general possibility that it will go into credit default. Under this model, the value of stock equity is modeled as a

call option In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an ...

on the value of the whole company – i.e. including the liabilities –

struck Struck is a surname. Notable people with the surname include: *Adolf Struck (1877–1911), German author *Hermann Struck (1876–1944), German artist *Karin Struck (1947–2006), German author *Paul Struck (1776-1820), German composer *Peter Struc ...

at the nominal value of the liabilities; and the equity market value thus depends on the volatility of the market value of the company assets. The idea applied is that, in general, equity may be viewed as a call option on the firm: since the principle of

limited liability Limited liability is a legal status in which a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a corporation, company or partnership. If a company that provides limited liability to it ...

protects equity investors, shareholders would choose not to repay the firm's debt where the value of the firm is less than the value of the outstanding debt; where firm value is greater than debt value, the shareholders would choose to repay – i.e. exercise their option – and not to liquidate. See . This is the first example of a "structural model", where bankruptcy is modeled using a microeconomic model of the firm's capital structure. Structural models are distinct from "reduced form models" – such as Jarrow–Turnbull – where bankruptcy is modeled as a statistical process. By contrast, the Merton model treats bankruptcy as a continuous probability of default, where, on the random occurrence of

default Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance), failure to satisfy the terms of a loan obligation or failure to pay back a loan ** Default judgment, a binding judgment in favor of ei ...

, the stock price of the defaulting company is assumed to go to zero.Robert Merton, "Option Pricing When Underlying Stock Returns are Discontinuous" ''Journal of Financial Economics'', 3, January–March, 1976, pp. 125–44. This microeconomic approach, to some extent, allows us to answer the question "what are the economic causes of default?"Nonlinear valuation and XVA under credit risk, collateral margins and Funding Costs
Prof. Damiano Brigo, UCLouvain

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