Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 25. Credit Risk Modeling Using Structural Models

MARK J.P. ANSON, PhD, JD, CPA, CFA, CAIA

President and Executive Director of Nuveen Investment Services

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

REN-RAW CHEN, PhD

Associate Professor of Finance, Rutgers University

MOORAD CHOUDHRY, PhD

Head of Treasury, KBC Financial Products, London

Abstract: The valuation of credit derivatives requires the modeling of credit risk. The two most commonly used approaches to model credit risk are structural models and reduced-form models. The first structural model for default risky bonds was proposed by Fischer Black and Myron Scholes, who explained how equity owners hold a call option on the firm. After that, Robert Merton extended the framework and analyzed risk debt behavior with the model. Robert Geske extended the Black-Scholes-Merton model to include multiple debts. Later, barrier structural models appeared as an easier solution for analyzing the risky debt problem.

Keywords: structural models, reduced-form models, credit risk modeling, barrier structural models, firm-value models, survival probability, Black-Scholes-Merton (BSM) model, Geske compound option model, Black-Cox model

Credit risk modeling is essential for the valuation of credit derivatives such as credit default swaps. There are two general approaches commonly employed to model credit risk: structural models and reduced-form models. In the structural approach, the model developer ...