Chapter 16

Reduced Form Credit Models and Credit Model Testing

For decades, researchers have looked for a more comprehensive, all-encompassing framework for risk management than the legacy approaches to credit risk that we review in Chapter 18, our “credit risk museum.” Sophisticated financial practitioners wanted a synthesis between models of default for major corporations and the credit scoring technology that has been used for decades to rate the riskiness of retail and small business borrowers. The framework long sought by bankers, the reduced form modeling framework, has blossomed dramatically in the years since the original Jarrow and Turnbull (1995) paper, “Pricing Derivatives on Financial Securities Subject to Credit Risk.” On December 10, 2003, the Federal Deposit Insurance Corporation (FDIC) announced that it was adopting the reduced form modeling framework for its new Loss Distribution Model (see the FDIC website for details of the model) after many years of studying the Merton model (which we describe in Chapter 18) as an alternative.

In this chapter, we introduce the basic concepts of the reduced form modeling technology and the reasons that it has gained such strong popularity.1

THE JARROW-TURNBULL MODEL

Many researchers trace the first reduced form model to Jarrow and Turnbull (1995), and we start our review of the reduced form model with that paper. Jarrow and Turnbull’s objective was to outline a modeling approach that would allow valuation, pricing, and hedging ...

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