The analysis of KMV-Merton model in forecasting default probability

Abstract

The paper gives brief review on two models called as Merton model and KMV-Merton model. Merton model is known as the triggers to the development of many credit risk models. Of all the credit risk models developed, the KMV-Merton model is the most popular. KMV-Merton model is developed to provide probabilistic assessment of firm's likelihood to default. Its ability in forecasting default for firms is proven when most of studies done by researchers and practitioners portray positive results. However in certain circumstances, the model becomes unavailable due to its structural constraints. Therefore, analysis is done on the KMV-Merton model so that modified default probability formulae are obtained for certain circumstances where the model becomes unavailable. Analysis is done using the mathematical approach. Then, the paper did data testing observation to justify the analysis. It is found that the results from the data testing satisfied the analysis done on KMV-Merton model. Thus, it verified that the modified default probability is true. The main contribution of this paper is it able to fill the gap exists in the KMV-Merton model in forecasting default for firms.