Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Systemic effects of the Merton model

David Merkel has posted on his The Aleph Blog a note that he wrote in 2004 about how widespread use of the Merton model to evaluate credit risk influences the corporate bond market itself. The Merton model regards risky debt as a combination of risk free debt and a short put option on the assets of the issuer. Credit risk assessment is then a question of valuing this put option – a process that relies largely on stock prices and implied volatilities. Merkel writes:

Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively, others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads. Because of this, the decline in implied volatility for the indices and individual companies has been a major factor in the spread compression that has gone on. I would say that the decline in implied volatility, and deleveraging, has had a larger impact than improving profitability on spreads.

The Merton model is probably under-utilized in India and so I have not encountered this problem. But Merkel is saying that in some countries, it is over used and over reliance on it can be a problem. The global financial crisis highlighted the dangers of outsourcing credit evaluation to the rating agencies. The Merton model in some ways amounts to outsourcing credit evaluation to the equity markets, and this too could end badly. I have wondered for some time now as to why advanced country central banks act as if they have adopted equity price targeting. If the Merton model is so influential, then the primary channel of monetary transmission to the credit markets would lie via equity markets and targeting equity prices suddenly makes a lot of sense to the central banks themselves.

But those who buy poor credit risks on the basis of Merton model credit assessments that have been flattered by QE inflated stock prices (and QE dampened volatilities) might be in for a rude surprise if and when the central banks decide to let equity markets find their natural level and volatility.

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