Work detail

The Applicability of Merton´s Credit Risk Model in the Czech Republic

Author: Mgr. Martin Peška
Year: 2007 - winter
Leaders: Mgr. Magda Pečená Ph.D.
Work type: Finance, Financial Markets and Banking
Language: English
Pages: 98
Awards and prizes: M.A. with distinction from the Dean of the Faculty of Social Sciences for an excellent state-final examination performance and for an extraordinarily good masters diploma thesis.
Abstract: Credit risk is the most important risk that financial institutions all around the world have to face. Even though the credit risk consists of several components, none are more important and more difficult to measure than the probability of default.
In my diploma thesis “The Applicability of Merton’s Credit Risk Model in the Czech Republic” I take a closer look at several methods of measurement of default probability. I start with the traditional accounting-based methods (Altman’s Z and Ohlson’s O) and present the methodology of credit ratings. But the main focus of this work lies on the Merton model, which derives the probabilities of default for publicly traded companies mainly from the prices and volatility of equity. I discuss the model’s assumptions, derive the key formulas, give step-by-step directions for its actual implementation and discuss thoroughly the model’s advantages, limitations, improvements and previous empirical tests of model quality.
Building on this theoretical ground, I compute the Merton-implied probabilities of default for Czech companies that are listed (and actively traded) on the Prague Stock Exchange. I compare the obtained results with the traditional indicators of credit risk, Altman’s Z- and Ohlson’s O- Scores with both original and updated coefficients, and with credit ratings from external rating agencies and Czech Sector Awards rankings. Based on these comparisons, I find that the traditional accounting-based measures are better predictors of the “real” situation of the company’s credit risk than the Merton model.
I discuss the possibilities to test the quality of the respective credit risk measures and perform an ordered logit regression on the company rankings using these measures of credit risk as explanatory variables. Because of small sample size and lack of dependable ground for model quality assessment, the results of the test are not statistically reliable. Nevertheless, the results obtained from the regression match the conclusions of the qualitative analysis.
The bottom line of this work is that the Merton model can under the conditions of a young and rather less liquid Czech capital market potentially be used as a source of information about the underlying credit risk but these default probabilities are, as for now, an insufficient measure of credit risk and some other models for the assessment of default probability should be used instead of or in addition to the Merton model.
Downloadable: Diploma Thesis of Martin Peška


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