Structural Models of Corporate Credit Risk

Abstract

Abstract Credit risk is related to the ability of a corporation or an individual to honor a financial obligation. A typical example is the default risk embedded in corporate bond markets. Structural models of credit risk are specifically designed to describe corporate credit risk using the capital structure of a firm. The capital structure comprises the firm's underlying assets, equities, and debts. A comprehensive approach even takes into account the optimal allocation of the firm's assets, the dividend policy of the management, and protective covenants of bond holders. The Moody's KMV, a corporation owned by the Moody's Investor Services, is the first rating agency to put a structural model into commercial use since the early 1990s. Popular structural models include, but are not limited to, the Merton model, the Black–Cox model, the Leland–Toft model, and the KMV approach. In this article, a brief overview of the formulation of a structural approach, specifications within the aforementioned models, and the implementation issues is given.