Asymmetric effects of noise in Merton default risk model: Evidence from emerging Asia

This study extends the application of the Merton (1974) model in six emerging Asian markets to estimate corporate default risk. First, we find that the Merton (1974) model suffers from disproportionate scaling between the book value of debt and the market value of equity due to illiquid corporate bond prices, which we refer to as market-bias. Second, the market-bias is predominantly observed in growth stocks with high price-to-book (PB) value ratios since they are significantly overpriced due to noise-trading. Hence, in the study, we propose the novel approach to control market-bias in the Merton (1974) model by disentangling the asymmetric effects of noise from growth stocks. Third, the analysis uncovered that default probabilities derived from the noise-adjusted Merton model are significantly higher than the Merton model for high and medium-grade firms. Our results provide useful insights to the lenders to ensure financial monitoring and control and the regulators to formulate proactive policies to safeguard economic stability. Besides, our results also benefit investors to assess the default risk of high net worth firms to pre-estimate the portfolio tail risk.