Use of options in the assessment of risk debt
With the given values, the theoretical call option value produced by the model is Loan officers and stock analysts utilize the Merton model to analyze a corporation's risk of credit default. This model allows for easier valuation of the company and also helps analysts determine if the company will be able to retain solvency by analyzing maturity dates and debt totals.
The Merton or Black-Scholes model calculates the theoretical pricing of European put and call options without considering dividends paid out during the life of the option.
The model can, however, be adapted to consider these dividends by calculating the ex-dividend date value of underlying stocks. The Merton Model makes the following basic assumptions: All options are European and are exercised only at the time of expiration. No dividends are paid out. Market movements are unpredictable efficient markets.
No commissions are included. Underlying stocks' volatility and mobile options platforms rates are constant. Returns on underlying stocks are regularly distributed.
Variables that were taken into consideration in the formula include options strike prices, present underlying prices, risk-free interest rates, and the amount of time before expiration. Key Takeaways InRobert Merton proposed a model for assessing the credit risk of a company by modeling the company's equity as a call option on its assets.
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This method allows for the use of the Black-Scholes-Merton option pricing model. The Merton model provides a structural relationship between the default risk and the assets of a company.
Merton was a famed American economist and Nobel Memorial Prize laureate, who befittingly purchased his first stock at age At MIT, he developed and published groundbreaking and precedent-setting ideas to be utilized in the financial world.
Merton then developed a derivative showing that hedging an option would remove all risk. In their paper, "The Pricing of Options and Corporate Liabilities," Black and Scholes included Merton's report, which explained the derivative of the formula.
Merton later changed the name of the formula to the Black-Scholes model. Compare Accounts.
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- By Sean Ross Updated Oct 14, Default risk and spread risk are the two components of credit riskwhich is a type of counterparty risk.