17 - Main credit modeling approaches

Abstract

This chapter reviews the credit risk literature with a special focus on the main modeling approaches for valuing instruments subject to default risk. The so-called firm value or structural approach to credit modeling traces its origins back to the work of Black and Scholes and the work of Merton. Credit models in this tradition focus on the analysis of the capital structure of individual firms in order to price their debt instruments. The discussion of the structural approach relies on some basic results regarding vanilla call and put options. In the chapter, most of these results are discussed only at an intuitive level. The reduced-form or default-intensity-based approach is also addressed in the chapter. The reduced-form approach does not directly attempts to link defaults to the capital structure of the firm. Instead, it models defaults to be exogenous stochastic events. Work in this strand of the credit risk literature is primarily interested in developing essentially statistical models for the probability of default over different time horizons. The chapter briefly compares the structural and reduced-form approaches both on methodological and empirical grounds. It also highlights the main thrust of a hybrid approach, motivated by the work of Duffie and Lando that incorporates elements of both the structural and reduced-form approaches.