Melton Model Essay

Section One
The asset value refers to the highest asset price that could be sold in an open but free market whereby the buyer and sellers are encouraged to sell the product, and there is no pressure applied to either. There is an effective way of determining the asset value in the market. This consist of assuming that an item would be sold depending on the identical product sold. The first step is assessing the product to be valued as well as noting their features as the manufacturer’s mark.

It is also essential to determine the age of the product as well as any interesting information like the previous owners. Another step is finding the list of identical products that have been recently sold (Bharath & Shumway, 2004). Then doing the average of the past sales of two or three such items by adding their prices then dividing the total product number (Elizalde, 2005). The default point is the number of standard division between the anticipated value of the asset and the maturity. The volatility of the asset is determined from the time series; this comprises the asset volatility at a given time. The distribution is assumed to lognormal this makes it easy to adopt the Black-Scholes-Merton equations. The assumptions made are more sensitive to the regular business cycles.

Section Two
Melton model helps in generating the default probability for the companies that are being investigated at any given time. One of the reasons for using this model is that it subtracts the firm value, the current debt from the estimated future market company value then dividing the outcome by the company volatility estimate.
Another critical advantage of Melton model is that it offers the best intuition as well as linking debt and equity prices. This makes the calculation easy hence saving time (Jarrow, 2009). The Melton model has an advantage in case it is used to carry out the capital structure arbitrage, for instance, determining and profit from the mispricing of the particular type of debt that is the equity for one firm. The asset value is determined by adding equity value and value of the liability. The Merton model makes some significant assumptions that are the company value obeys geometric Brownian motion (Afik & Benninga, 2009).

The sensitivity is the method used to assess the independent variables that influence a specific variable based on the particular assumptions made during the analysis. The sensitivity analysis adoption relies on a different variable that is in a certain boundary, for instance, a small change in interest rate effect on bond’s price. The sensitivity analysis has to be adopted for any given system or the activity. Sensitivity objective plays an imperative role in assessing the output by merely changing in one input at the same time keeping the other information constant. In this case, it is important to note that sensitive objective work on the real attitude that is the change in the model and observation of behavior.

The sensitivity objective has to consist of different elements such as experimental design. This incorporates parameters that have played different roles. This consists of checking on the number of parameters that is varied at a certain point. It also consists of assigning the various values before the study. The sensitivity objective relies on six significant assumptions as mentioned. This means that for it to accomplish its objectives, it has to put these assumptions into consideration. If they are considered the chances of meeting, the stated goals become low.

Reference
Afik, Z., & Benninga, S. (2009). A Markov Model of Expected Bond Returns. Tel-Aviv University.
Bharath, S. T., & Shumway, T. (2004). Forecasting default with the KMV-Merton model.
Elizalde, A. (2005). Credit risk models IV: Understanding and pricing CDOs. CEMFI and Universidad Publica de Navarro, download: www. cemfi. es/∼ elizalde.
Jarrow, R. A. (2009). Credit risk models. Annu. Rev. Financ. Econ., 1(1), 37-68.