Chapter 19 Credit Risk

[Bill SD]

Page 7 of the Acted Notes (section: Approaches to modelling Credit Risk) quotes the Core Reading:

"Structural models are explicit models for a corporate entity issuing both equity and debt. They aim to link default events explicitly to the fortunes of the issuing corporate entity....
An intensity-based model is a particular type of continuous-time reduced-form model. It typically models the jumps between different states (usually credit ratings) using transition intensities. The disadvantage of reduced-form models is that they sometimes lack the clarity of structural models.."

Two questions:
1) Why are structural models called 'explicit' even though F(t) and sigma (the volatility) are unobservable and their valuation requires the Black Scholes assumptions including that F(t) follows Geometric Brownian Motion? Does 'explicit' in this context mean that we evaluate F(t) purely based on current information, rather than requiring estimates of probability of default at a future date?

2) What does the Core Reading mean that reduced-form models 'lack the clarity' of structural models? Does 'clarity' refer to the explicitness of structural models (discussed above) or another characteristic? [I certainly don't have clarity ]

 

[CapitalActuary]

The key phrase is "They aim to link default events explicitly to the fortunes of the issuing corporate entity". In other words, they are explicit because they are laying out more clearly the connection between what is going on in a company and the credit risk.

This is in contrast to a reduced form model, where we don't think about the balance sheet of a company at all. Instead we abstract away the idea of a company, and model the probability of default as a parameter rather than something which results from fluctuations in the company's fortunes. It's in this sense that a reduced form model lacks the clarity of a structural model. In a reduced form model I don't have an idea of what the company's balance sheet looks like and how this leads to default - I simply brush all of that under the rug and say it defaults with some probability (and I don't care how).

 

[Bill SD]

The key phrase is "They aim to link default events explicitly to the fortunes of the issuing corporate entity". In other words, they are explicit because they are laying out more clearly the connection between what is going on in a company and the credit risk.

This is in contrast to a reduced form model, where we don't think about the balance sheet of a company at all. Instead we abstract away the idea of a company, and model the probability of default as a parameter rather than something which results from fluctuations in the company's fortunes. It's in this sense that a reduced form model lacks the clarity of a structural model. In a reduced form model I don't have an idea of what the company's balance sheet looks like and how this leads to default - I simply brush all of that under the rug and say it defaults with some probability (and I don't care how).

Thanks for the very fast response. Of course probabilities of default are related to the fortune of the company since they are derived from historic (and predicted) defaults of similar companies. But yes, take your point about reduced form models disregarding the exact structure and movement in balance sheet.