Structural versus Reduced‐Form Models: A New Information‐Based Perspective

Abstract

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 a predictable default time. In contrast, 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, this 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 time 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.

Application of Vine Copulas to Credit Portfolio Risk Modeling

“…To model the former, we apply a structural model, which originates in [11] and in which default happens when the asset value of a company falls below its liabilities (Alternative obligor-specific default risk models are reduced form (or intensity) models, see [12,13]. For a comparison of both model classes, see [14] or [15]. Most of the criticism of structural models concerns the accuracy of credit spread predictions, whereas the focus of this paper is on the correlation structure among borrowers.).…”

On the compensator of the default process in an information-based model

“…In this sense, totally inaccessible default times seem to be the best candidates for modelling times of bankruptcy. We refer, among others, to the papers of Jarrow and Protter (2004) and of Giesecke (2006) on the relations between financial information and the properties of the default time, and also to the series of papers of Jeanblanc and Le Cam (2008,2010. It is remarkable that in our setting the default time is a totally inaccessible stopping time under the common assumption that it admits a continuous density with respect to the Lebesgue measure.…”

The Company Fundamental Analysis and the Default Risk Ratio

“…In this perspective, among the other studies, it can be useful the approach based on the available information (Jarrow & Protter, 2004). In this sense, the main difference between these two approaches is due to the information assumed known: i) structural-form models assume to have the same information as the firm's management with regard assets and liabilities with consequence of a complete knowledge of the firm's condition.…”

“…This assumption about information implies that the firm's default time is inaccessible. Based on this perspective in which key role is played by the available information, the debate about the two approaches change the focus by shifting from the model that is the best in terms of forecasting performance to the model that is the best on the basis of the information available (Jarrow & Protter, 2004).…”