A valuation approach which is used to draw an estimation of the expected default frequency and recovery rates of a specific firm. It is based on Robert Merton’s model-of-the-firm methodology which maintains that a firm’s debt can be valued as a put option of the underlying asset value of the firm, while equity can be viewed as a call option on the value of assets with a strike price equal to the face value of debt.
In other words, this approach considers the equity holders of a firm as holding a put option to pay off the debt holders with whichever is lesser of two values: the face value of the debt or the overall value of the firm’s assets. It follows that the overall economic value of the firm’s debt to the debt holders must be the face value of the debt minus the value of this put option.
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