Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853, and Kamakura Corporation
Donald R. van Deventer
Kamakura Corporation, Manoa Innovation Center, Suite 138, 2800 Woodlawn Drive, Honolulu, Hawaii 96822
University of Hawaii, Honolulu, Hawaii 96822, and Kamakura Corporation
This paper presents a robust test of Merton’s structural model for credit risk that does not depend on either estimated parameters for the firm’s value or estimated default probabilities. We derive a test for the consistency of the changes in observed debt and equity prices (positive or negative changes) with the Merton model. For all firms selected and for all debt issues examined, the evidence strongly rejects Merton’s structural model.