Default risk is the uncertainty surrounding a firm’s ability to pay its creditors. Prior to default, we have no way of distinguishing for certain the firms that will default from those that will not. The best we can do is estimate the probability that a firm will default.
One way to tackle this problem is through the option pricing approach to default risk, sometimes known as the Merton approach (Merton, 1974). This approach builds on the idea that an equity holder has an implicit option on the
Back to Top