Bank of England research backs Merton model

In an article published today in the Bank of England's June Financial Stability Review, Merxe Tudela and Garry Young describe how they tested the Merton model against a database of UK company failures and defaults between 1990 and January 2003. The Merton model – which shows how the probability of default of an individual company can be inferred from its market valuation – was found to be useful in ranking companies according to their riskiness.

A key finding of the study was that: "The mean value of the average one-year PD [probability of default] for our entire sample is 47.3% for those companies that went into liquidation and 5.4% for those that did not."

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