The Credit Market Handbook: Advanced Modeling Issues

CHAPTER 6

Structural versus Reduced-Form Models: A New Information-Based Perspective

Robert A. Jarrow ^a,* and Philip Protter^b

This chapter compares structural versus reduced-form credit risk models from an information-based perspective. We show that the difference between these two model types can be characterized in terms of the information assumed known by the modeler. Structural models assume that the modeler has the same information set as the firm's manager—complete knowledge of all the firm's assets and liabilities. In most situations, this knowledge leads to a predictable default time. In contrast, reduced-form models assume that the modeler has the same information set as the market—incomplete knowledge of the firm's condition. In most cases, this imperfect knowledge leads to an inaccessible default time. And so we argue that the key distinction between structural and reduced-form models is not whether the default time is predictable or inaccessible, but whether or not the information set is observed by the market. Consequently, for pricing and hedging, reduced-form models are the preferred methodology.

1. INTRODUCTION

For modeling credit risk, two classes of models exist: structural and reduced-form. Structural models originated with Black and Scholes (1973) and Merton (1974), and reduced-form models originated with Jarrow and Turnbull (1992), and were subsequently studied by Jarrow and Turnbull (1995), Duffie and Singleton (1999), and others. These models are viewed ...