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

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  • Jarrow, Robert A.

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.

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  • Jarrow, Robert A., 2011. "Credit market equilibrium theory and evidence: Revisiting the structural versus reduced form credit risk model debate," Finance Research Letters, Elsevier, vol. 8(1), pages 2-7, March.
  • Handle: RePEc:eee:finlet:v:8:y:2011:i:1:p:2-7
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    2. Forte, Santiago & Lovreta, Lidija, 2012. "Endogenizing exogenous default barrier models: The MM algorithm," Journal of Banking & Finance, Elsevier, vol. 36(6), pages 1639-1652.
    3. Chen, Son-Nan & Chiang, Mi-Hsiu & Hsu, Pao-Peng & Li, Chang-Yi, 2014. "Valuation of quanto options in a Markovian regime-switching market: A Markov-modulated Gaussian HJM model," Finance Research Letters, Elsevier, vol. 11(2), pages 161-172.
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