Predictive Merton
Firm-value models of default are the basis of KMV’s proprietary default prediction methodology. Recently, critics have attacked the methodology for its failure to include other potentially useful default indicators. Here, Stephen Kealhofer and Matthew Kurbat respond, arguing that such indicators fail to improve upon the KMV methodology’s predictive power.
One way to tackle this problem is through the option pricing approach to default risk, sometimes known as the Merton approach (Merton, 1974). This approach builds on the idea that an equity holder has an implicit option on the
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