Merton Model and Default Probability Analysis

Very Hard Credit Analysis And Valuation Structural Models

A corporate bond has a face value of $1,000 and is scheduled to mature in 5 years. The company has a current credit rating of 'BB' and is experiencing fluctuations in its earnings due to market volatility. Analysts are using a structural model, specifically the Merton model, to evaluate the default probability associated with the bond.

According to the Merton model, the default threshold is determined by the company's asset value and its liability structure. The company's total liabilities are $800 million, and the current market value of its assets is estimated to be $1.2 billion. What can be inferred about the probability of default for this bond under the Merton model framework?

The default probability is low because the company's assets significantly exceed its liabilities.

The default probability is high due to the company's unstable earnings profile.

The default probability cannot be assessed without knowing the volatility of the company's assets.

Hint

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