How Good is Merton Model at Assessing Credit Risk? Evidence from India

by Amit Kulkarni of the National Institute of Bank Management,
Alok Kumar Mishra of the National Institute of Bank Management, and
Jigisha Thakker of the National Institute of Bank Management

Fall 2005

Abstract: This paper models the default probabilities and credit spreads for select Indian firms in the Black-Scholes-Merton framework. Counter to previous research, we show that the objective (or ‘real') probability estimates are higher than the risk-neutral estimates over the sample period. However, the probability measure is found to be robust to the ‘default trigger point'. The model output also compares favorably with the default rate reported by CRISIL's Average 1-year rating transitions as well as the Altman Z-score measure. However it does not generate spreads as high as those observed in the corporate bond market. Perhaps not surprisingly, this is consistent with the received literature on credit spreads.

JEL Classification: G13, G33.

Keywords: Merton Model, Probability of Default, Credit Spreads.

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