Under this model, the value of stock equity is modeled as a
call option on the
value of the whole company – i.e. including the liabilities –
struck at the nominal value of the liabilities; and the equity market value thus depends on the volatility of the market value of the company assets. The idea applied is that, in general, equity may be viewed as a call option on the firm: since the principle of
limited liability protects equity investors, shareholders would choose not to repay the firm's debt where the value of the firm is less than the value of the outstanding debt; where firm value is greater than debt value, the shareholders would choose to repay – i.e.
exercise their option – and not to liquidate. See and . This is the first example of a "structural model", where bankruptcy is modeled using a microeconomic model of the firm's
capital structure. Structural models are distinct from "reduced form models" – such as
Jarrow–Turnbull – where bankruptcy is modeled as a statistical process. By contrast, the Merton model treats
bankruptcy as a continuous
probability of default, where, on the random occurrence of
default, the stock price of the defaulting company is assumed to go to zero. This microeconomic approach, to some extent, allows us to answer the question "what are the economic causes of default?" Large financial institutions
employ default models of both the structural and reduced-form types. ==KMV Model==