Merton Model

The Merton Model is a way to assess a company's financial health and its risk of defaulting on debt. It treats a company's value like a fluctuating stock price, influenced by market factors. If the company’s assets fall below a certain level—specifically, the amount owed on debt—it’s considered at risk of defaulting. The model uses formulas from options theory, particularly the idea of a call option, to estimate the probability that the company's value will dip below this critical threshold. This helps investors and lenders evaluate how likely a company is to fail financially.