Structural and Reduced Form Credit Models

Basically the key difference is in the assumptions/needs of the two models. Structural is akin to an
option analogy (and assumes that a company's assets trade like a stock). Structural is more theory
based/missing key components (but it gives you a basic understanding of what you're looking for).
Reduced form models builds upon this and uses historical trading data based on debt that trades in the
firm; it also incorporates macro conditions + company specific conditions. I copy/pasted my notes on the
section - hope it helps

A) Structural models underlie the default probability and credit analytic that develop ratings

-Structural models originated to understand economics of firms liabilities based on structure of BS

-assume a simple balance sheet / assume assets company trade

Equity holders have limited liabilities to extent of company assets

-firm is like a call option; owning a firms equity is like owning a call option on firm’s assets (key point to
structural model)

Debt holders get either PAR or COMPANY ASSETS at expiration:

a) probability of default depends if company assets fall below par

b) loss given default = PAR – COMPANY ASSETS at expiration

-it’s like a call with face value of debt as strike; worthless if you don’t hit it

Structural Model assumptions (same as option pricing)

1. firms assets trade arbitrage free – no transaction costs, high liquidity, no bid-ask spreads

2. risk free rate is constant (no interest rate risk in model)

3. firms assets have a lognormal distribution with a mean/variance

4. volatility assumption of SD per year

Valuation – basically use a variation of Black schools to get PV of expected loss

-this is superior to expected loss b/c it includes TVM + Credit Risk Premium

Inputs: Cannot use historical inputs (company’s assets don’t actually trade) so we must use implicit rates

Strengths:

1. provides option analogy to understand firms default probability + recovery rate

2. it can be estimated using only current market prices (black schools)

Weaknesses:

1. default probability and recovery rate depend on BS, and BS are complex

2. can only be estimated with CALIBRATION (implied rates from market prices of firm equity)

3. biased bc we can only use implicit inputs

4. ignores business cycle

B) Reduced Form Models – originated to overcome structural models weakness (that company assets
trade)

-they replace this assumption by assuming SOME OF THE FIRMS DEBT TRADES

-called reduced form b/c they impose assumptions on outputs of structural model (probability of default
+ loss given default) rather than on BS itself.

-this gives model tremendous flexibility in matching actual market condition

Reduced Form Model Assumptions:

1. arbitrage free markets, where company debt trades

2. risk free rate is stochastic (capturing interest rate risk)

3. state of economy can be described by stochastic variables that represent macro factors

4. firm defaults at random time when economy is in state of X

5. given macro factors X, company default represents idiosyncratic risk (nonsystematic risk)

6. given default, % loss on company debt = 0 < X < 1

-assumptions 4/5/6 are imposed on outputs of structural mode, so we assume we KNOW PROBABILITY
OF DEFAULT AND LOSS GIVEN DEFAULT

-4 focuses on where economy is heading, 5 is company specific, 6 is how much debt is worth

We can use historical OR implicit methods to estimate model parameters (we can use historical b/c debt
does trade + macro factors are observable)

Strengths:

1. we can use historical estimates

2. credit risk measures changing macro conditions

3. we don’t need to specific a firms BS structure

Weaknesses:

1. hazard rate estimation – using past to predict future

Comparisons of Models:

Three approaches to evaluate Credit Risk = ratings, structural models, reduced form models

-ratings least accurate (lag issue in ratings change, downplays macro factors

-reduced form are best b/c they can use historical estimates + consider macro factors better (plus more
realistic assumption than structural)