Inefficient markets and credit risk modeling: Why Merton's model failed

In the current decade, modeling credit risk is increasingly gaining attention by risk managers of banks and researchers. Among the available credit risk models, Merton's equity-based approach is considered as a pioneering tool for measuring default risks. From the day it was developed by Robert Merton, it is being regarded as one of the primary model of assessing credit risk. In this model the default process is endogenous, and relates to the capital structure of the firm. The model presumes that the only source of uncertainty in equity prices is the uncertainty in the firm's net asset value. Therefore, the only risk considered is the firm specific risk. Ironically, the above market condition holds only when the market is efficient. The model developed in the present paper is virtually a modification of Merton's model. However, it is not subject to the limitation of that model. Therefore, the modified model will necessarily widen the scope of equity-based modeling ranging from a strict efficient market to an inefficient market.