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Encyclopedia of Financial Models, 3 Volume Set by Frank J. Fabozzi

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Structural Models in Credit Risk Modeling

ABEL ELIZALDE, PhD

Credit Derivatives Strategy, J.P. Morgan

Abstract: Structural models and reduced-form models are the two primary types of credit risk models that seek to statistically describe default processes. Structural models use the evolution of firms' structural variables, such as asset and debt values, to model the time of default. In contrast, reduced-form models do not consider structural variables in an explicit manner when modeling default processes; instead, they model default as an exogenously driven process. Structural models include first passage models, liquidity process models, and state dependent models.

In this entry we review the structural approach for credit risk modeling, both considering the case of a single firm and the case with default dependencies between firms. In the single firm case, we review the Merton (1974) model and first passage models, examining their main characteristics and extensions. Liquidation process models extend first passage models to account for the possibility of a lengthy liquidation process, which might or might not end up in default. Finally, we review structural models with state-dependent cash flows (recession vs. expansion) or debt coupons (rating-based). The estimation of structural models is also addressed in this entry, covering the different ways proposed in the literature. Finally, we present some approaches to model default dependencies between firms within the structural ...

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