Credit market equilibrium theory and evidence: Revisiting the structural versus reduced form credit risk model debate

Abstract

There are two competing paradigms for modeling credit risk: the structural and reduced form models. This paper applies our knowledge of credit market equilibrium to this debate. We show that credit markets have asymmetric information in the borrowing and lending relationship which influence equilibrium prices. Reduced form models are consistent with asymmetric equilibrium models, but structural models are not. This implies that structural models should not be used for pricing, hedging, or risk management.