| Structural Models | Reduced-Form Models | |
| What is it? | Predict why a default may occur.
Based on insights from option pricing theory. The values for debt and equity at time T can be expressed as: D(T) + E(T) = A(T) E(T) = Max[A(T) – K,0] D(T) = A(T) – Max[A(T) – K,0] Probability of default is endogenous to the model. |
Predict when a default may occur (default time).
Statistical methods are used. Default intensity (probability of default over the next period) is estimated using regression analysis on company-specific and macro-economic variables. Default is an exogenous variable that occurs randomly. |
| Assumptions | Assets are actively traded.
Liabilities easily determined. |
Inputs are observable variables including historical data. |
| Strengths | Economic explanation for default. | Practical assumptions.
Business cycle is considered. |
| Weaknesses | Unrealistic assumptions.
Business cycle not considered. |
Economic reasons for default are not explained.
Default is a surprise and can happen at any time. |
| Used by | Company managers, commercial bankers, rating agencies. (i.e. entities that have access to the internal information needed for this model.) | Financial analysts trying to value debt securities. (The information required is easily available to external parties) |
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