IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article

Does modeling framework matter? A comparative study of structural and reduced-form models

  • Yalin Gündüz

    ()

  • Marliese Uhrig-Homburg

    ()

This study provides a rigorous empirical comparison of structural and reduced-form credit risk frameworks. The literature differentiates between structural models that are based on modeling of the evolution of the balance sheet of the issuer, and reduced-form models that specify credit risk exogenously by a hazard rate process. Until now, there has been no common agreement in academia and practice on which model framework better captures credit risk. As major difference we focus on the discriminative modeling of the default time. In contrast to the previous literature, we calibrate both approaches to the same data set, apply comparable estimation techniques, and assess the out-of-sample prediction quality on the same time series of credit default swap prices. As our empirical implementations of both approaches rely on the same market information we are able to judge whether empirically the model structure itself makes an important difference. Interestingly, our study shows that the models’ prediction power are quite close on average indicating that for pricing purposes the modeling type does not greatly matter compared to the input data used. Still, the reduced-form approach outperforms the structural for investment-grade names and longer maturities. In contrast the structural approach performs better for shorter maturities and sub-investment grade names. Copyright Springer Science+Business Media New York 2014

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://hdl.handle.net/10.1007/s11147-013-9090-8
Download Restriction: Access to full text is restricted to subscribers.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Springer in its journal Review of Derivatives Research.

Volume (Year): 17 (2014)
Issue (Month): 1 (April)
Pages: 39-78

as
in new window

Handle: RePEc:kap:revdev:v:17:y:2014:i:1:p:39-78
Contact details of provider: Web page: http://www.springerlink.com/link.asp?id=102989

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
  2. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-52, September.
  3. Jan Ericsson & Kris Jacobs & Rodolfo A. Oviedo, 2004. "The Determinants of Credit Default Swap Premia," CIRANO Working Papers 2004s-55, CIRANO.
  4. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  5. Houweling, Patrick & Vorst, Ton, 2005. "Pricing default swaps: Empirical evidence," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1200-1225, December.
  6. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
  7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  8. Long Chen & Pierre Collin-Dufresne & Robert S. Goldstein, 2009. "On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3367-3409, September.
  9. Ronn, Ehud I & Verma, Avinash K, 1986. " Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-95, September.
  10. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
  11. Gurdip Bakshi & Dilip Madan & Frank Xiaoling Zhang, 2006. "Investigating the Role of Systematic and Firm-Specific Factors in Default Risk: Lessons from Empirically Evaluating Credit Risk Models," The Journal of Business, University of Chicago Press, vol. 79(4), pages 1955-1988, July.
  12. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
  13. Babbs, Simon H. & Nowman, K. Ben, 1999. "Kalman Filtering of Generalized Vasicek Term Structure Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(01), pages 115-130, March.
  14. Chen, Ren-Raw & Cheng, Xiaolin & Fabozzi, Frank J. & Liu, Bo, 2008. "An Explicit, Multi-Factor Credit Default Swap Pricing Model with Correlated Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(01), pages 123-160, March.
  15. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
  16. Yalin Gündüz & Torsten Lüdecke & Marliese Uhrig-Homburg, 2007. "Trading Credit Default Swaps via Interdealer Brokers," Journal of Financial Services Research, Springer;Western Finance Association, vol. 32(3), pages 141-159, December.
  17. Marliese Uhrig-Homburg, 2002. "Valuation Of Defaultable Claims – A Survey," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 54(1), pages 24-57, January.
  18. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  19. Jin-Chuan Duan & Jean-Guy Simonato, 1995. "Estimating and Testing Exponential Affine Term Structure Models by Kalman Filter," CIRANO Working Papers 95s-44, CIRANO.
  20. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  21. Eugene F. Fama, 2002. "Testing Trade-Off and Pecking Order Predictions About Dividends and Debt," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 1-33, March.
  22. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-25, July.
  23. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
  24. Hongming Huang & Yildiray Yildirim, 2008. "Leverage, options liabilities, and corporate bond pricing," Review of Derivatives Research, Springer, vol. 11(3), pages 245-276, October.
  25. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-44, January.
  26. Nashikkar, Amrut & Subrahmanyam, Marti G. & Mahanti, Sriketan, 2011. "Liquidity and Arbitrage in the Market for Credit Risk," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(03), pages 627-656, June.
  27. Pierre Collin-Dufresne, 2001. "Do Credit Spreads Reflect Stationary Leverage Ratios?," Journal of Finance, American Finance Association, vol. 56(5), pages 1929-1957, October.
  28. repec:bla:jfnres:v:22:y:1999:i:1:p:107-130 is not listed on IDEAS
  29. Jean Helwege & Christopher M. Turner, 1999. "The Slope of the Credit Yield Curve for Speculative-Grade Issuers," Journal of Finance, American Finance Association, vol. 54(5), pages 1869-1884, October.
  30. Frank Zhang, 2010. "An empirical analysis of alternative recovery risk models and implied recovery rates," Review of Derivatives Research, Springer, vol. 13(2), pages 101-124, July.
  31. Harjoat S. Bhamra & Lars-Alexander Kuehn & Ilya A. Strebulaev, 2010. "The Aggregate Dynamics of Capital Structure and Macroeconomic Risk," Review of Financial Studies, Society for Financial Studies, vol. 23(12), pages 4187-4241, December.
  32. Schaefer, Stephen M. & Strebulaev, Ilya A., 2008. "Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds," Journal of Financial Economics, Elsevier, vol. 90(1), pages 1-19, October.
  33. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
  34. Geyer, Alois L J & Pichler, Stefan, 1999. "A State-Space Approach to Estimate and Test Multifactor Cox-Ingersoll-Ross Models of the Term Structure," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 22(1), pages 107-30, Spring.
  35. Anderson, Ronald & Sundaresan, Suresh, 2000. "A comparative study of structural models of corporate bond yields: An exploratory investigation," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 255-269, January.
  36. Jankowitsch, Rainer & Pullirsch, Rainer & Veza, Tanja, 2008. "The delivery option in credit default swaps," Journal of Banking & Finance, Elsevier, vol. 32(7), pages 1269-1285, July.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:kap:revdev:v:17:y:2014:i:1:p:39-78. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Sonal Shukla)

or (Rebekah McClure)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.