Friday, June 27, 2008

Car Beeper Like Merton Model

I was trying to find my car in the parking lot, and I have a button on my key that makes the horn honk. Unfortunately, you need to be within about 10 feet for it to work, making it pretty useless (I can see it by then). Reminds me of the Merton model. This model predicts every bankruptcy with probability 1. The gist is this model is basically a z-score on the firm's total value (Liabilities + Equity) compared to just Liabilities. The price of the stock goes to zero, until, eventually, bankruptcy. Brilliant!

The graph above is from Saunders and Allen (Credit Risk Management, 2002), and it highlights the issue. On one hand, the Agencies missed the boat, and had it rated investment grade until it defaulted. On the other hand, KMV's merton model would have also rated it very highly until only nine month's prior to default. For most lenders, this means KMVs signal is too late to be of use, because most lenders can't sell their loans as they degrade.

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