Merton distance to default
Relate default risk to assets, debt and uncertainty
Merton’s structural model treats equity as a claim on firm assets and default as assets falling below promised debt at maturity. Distance to default standardises the separation between modelled asset value and a default boundary using asset volatility and horizon. Practical implementations infer unobserved asset quantities from market equity and balance-sheet information, often modifying the original debt structure.
Choose this for structural credit-risk research on listed firms when market equity, equity volatility and debt information are available. The assumed asset process and default boundary must be defensible for the application.
Strengths
- Connects market equity and capital structure through an explicit model
- Produces a forward-looking structural risk indicator conditional on assumptions
Limitations
- Asset value and volatility are latent and must be estimated
- Simplified debt maturity and diffusion assumptions limit realism
Know the boundary
A structural distance measure is not automatically a calibrated real-world default probability. Merton’s original default occurs at debt maturity.