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101 Concepts for the Level I Exam

Essential Concept 70: Structural Versus Reduced-Form Models

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)