Chapter 19 - Main Credit Modeling Approaches

Abstract

In this chapter, we review and summarize the credit risk literature with a special focus on the main modeling approaches for valuing instruments subject to default risk. Section 19.1 summarizes the so-called firm value or structural approach to credit modeling, which traces its origins to the work of Black and Scholes [27] and Merton [28]. The reduced-form or default-intensity-based approach is addressed in Section 19.2, where we discuss models based on the seminal work of Jarrow and Turnbull [30]. In Section 19.3, we briefly compare the structural and reduced-form approaches, both on methodological and empirical grounds. That section also highlights the main thrust of a “hybrid” approach—motivated by the work of Duffie and Lando [31]—that incorporates elements of both the structural and reduced-form approaches. The chapter concludes with Section 19.4, where we outline the basic tenets of the ratings-based approach to credit modeling.