STRUCTURAL VERSUS REDUCED FORM MODELS: A NEW INFORMATION BASED PERSPECTIVE

This paper compares structural versus reduced form credit risk models from an information based perspective. We show that the difference between these two model types can be characterized in terms of the information assumed known by the modeler. Structural models assume that the modeler has the same information set as the firm's manager - complete knowledge of all the firm's assets and liabilities. In most situations, this knowledge leads to predictable default time. In contracts, reduced form models assume that the modeler has the same information set as the market - incomplete knowledge of the firm's condition. In most cases, the imperfect knowledge leads to an inaccessible default time. As such, we argue that the key distinction between structural and reduced form models is not whether the default is predictable or inaccessible, but whether the information set is observed by the market or not. Consequently, for pricing and hedging, reduced form models are the preferred methodology.

[1]  R. Jarrow,et al.  A Markov Model for the Term Structure of Credit Risk Spreads , 1997 .

[2]  D. Duffie.  Dynamic Asset Pricing Theory , 1992 .

[3]  D. Duffie,et al.  Term Structures of Credit Spreads with Incomplete Accounting Information , 2001, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[4]  F. Black,et al.  VALUING CORPORATE SECURITIES: SOME EFFECTS OF BOND INDENTURE PROVISIONS , 1976 .

[5]  K. Giesecke.  Default and Information , 2005 .

[6]  D. Madan,et al.  Pricing the risks of default , 1998 .

[7]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[8]  J. Duan.  MAXIMUM LIKELIHOOD ESTIMATION USING PRICE DATA OF THE DERIVATIVE CONTRACT , 1994 .

[9]  T. Bielecki,et al.  Credit Risk: Modeling, Valuation And Hedging , 2004 .

[10]  Jan Ericsson,et al.  The Valuation of Corporate Liabilities: Theory and Tests , 2002 .

[11]  Yu. A. Rozanov,et al.  On Stochastic Integration and Differentiation , 1999 .

[12]  R. Jarrow,et al.  Counterparty Risk and the Pricing of Defaultable Securities , 1999 .

[13]  David Lando,et al.  Credit Risk Modeling: Theory and Applications , 2004 .

[14]  L. Fisher.  Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation , 1984 .

[15]  Chenchuramaiah T. Bathala.  Forecasting Default in the Face of Uncertainty , 2005 .

[16]  G. Duffee.  Estimating the Price of Default Risk , 1996 .

[17]  D. Shimko,et al.  The Pricing of Risky Debt When Interest Rates are Stochastic , 1993, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[18]  Eduardo S. Schwartz,et al.  A Simple Approach to Valuing Risky Fixed and Floating Rate Debt , 1995 .

[19]  Miikka Tauren.  A Model of Corporate Bond Prices with Dynamic Capital Structure , 1999 .

[20]  D. Duffie,et al.  Modeling term structures of defaultable bonds , 1999 .

[21]  R. C. Merton,et al.  On the Pricing of Corporate Debt: The Risk Structure of Interest Rates , 1974, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[22]  K. Giesecke,et al.  Forecasting Default in the Face of Uncertainty , 2004 .

[23]  P. Protter,et al.  Modeling Credit Risk with Partial Information , 2004, math/0407060.

[24]  David Lando,et al.  On cox processes and credit risky securities , 1998 .

[25]  R. Jarrow,et al.  A robust test of Merton's structural model for credit risk , 2003 .

[26]  C. Lo,et al.  Pricing Corporate Bonds With Dynamic Default Barriers , 2003 .

[27]  R. Jarrow,et al.  Pricing Derivatives on Financial Securities Subject to Credit Risk , 1995 .

[28]  Shigeo Kusuoka,et al.  A Remark on default risk models , 1999 .