|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.
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)|