The Effect of Stock Market Overvaluation on Merton’s Model

Jakub TABAČEK

Abstract: This paper tests the effect of equity market misvaluation of publicly traded companies on their respective default probabilities. We use a natural experiment of Dot Com bubble that allows us to isolate the misvaluation effect of stock market.  Merton’s credit risk model is used for estimating individual default probabilities. Probit regression is estimated to compare the model’s predictive ability during Internet bubble with the rest of the sample while controlling for industry and economic conditions. Evidence suggests that market overvaluation causes Merton’s model to underestimate credit risk.

Keywords: Merton Models; Corporate Failure; Implied Default Probabilities

JEL: G12, G13 

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