The Merton model does not allow for default jumps in predicting the probability of default. This is one of the inherent assumptions under the Merton model, which assumes that there’s zero chance of a sudden or unexpected jump in the value of the firm. However, this assumption has been heavily criticized as it does not align with the reality of financial markets. Most of the default events witnessed in the markets often catch investors by surprise, indicating that defaults are not as predictable as the Merton model suggests. The inability to account for jumps in the firm value in the Merton model implies that it may not accurately predict the probability of default.

Choice A is incorrect. The Merton model, despite its limitations, has been found to be effective in predicting default risk for noninvestment grade bonds. It is not outperformed by a naïve model in this respect.

Choice B is incorrect. The Merton model may struggle with valuing firms that have issued numerous debts due to the complexity of the debt structure and the difficulty in accurately estimating asset volatility.

Choice C is incorrect. The Merton model does not assume that firm value is normally distributed. Instead, it assumes that the firm’s asset value follows a geometric Brownian motion, which implies log-normal distribution of firm value.

Things to Remember

• The Merton model's assumption of gradual default risk, as opposed to abrupt changes, may not align with real market scenarios where defaults can be sudden and unexpected.