Credit Risk Models III: Reconciliation Reduced - Structural Models

by Abel Elizalde of CEMFI and Universidad Pública de Navarra

April 2006

Abstract: In recent years, some papers have tried to bridge the gap between the two main approaches in credit risk modelling: structural and reduced form models. Based on incomplete information versions of standard structural models, they are able to obtain reduced form models in which the intensity of default is not given exogenously but determined endogenously within the model and it is a function of the firm's characteristics and the level of information that investors posses.

The key element to link both approaches lies in the model's information assumptions. Using a specification of a structural model where investors do not have complete information about the dynamics of the processes which trigger the firm's default, these models derive a cumulative rate of default consistent with a reduced form model.

This paper pretends to be an introduction to this literature, providing some of the basic insights of the modelling structure and the main conclusion and results.

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