Reduced‐Form versus Structural Models of Credit Risk: A Case Study of Three Models

Abstract

This chapter empirically compares credit risk structural models of R. Merton and that of O. Vasicek & S. Kealhofer (VK) and reduced model of J. Hull and A. White (HW). While doing so, it proposes that two useful purposes for credit models are default discrimination and relative value analysis. The chapter tests the ability of the Merton and VK models to discriminate defaulters from non-defaulters based on default probabilities generated from information in the equity market. It finds the VK and HW models exhibit comparable accuracy ratios and substantially outperform the simple Merton model. It also finds the VK model tends to do the best across the full sample and relative subsamples except for cases where an issuer has many bonds in the market. In this case, the HW model tends to do the best. The empirical evidence will assist market participants in determining which model is most useful based on their "purpose in hand." On the structural side, a basic Merton model is not good enough; appropriate modifications to the framework make a difference. On the reduced-form side, the quality and quantity of data make a difference; many traded issuers will not be well modeled in this way unless they issue more traded debt.

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