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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

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File URL: http://hdl.handle.net/10.1007/s11147-013-9090-8
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Article provided by Springer in its journal Review of Derivatives Research.

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

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Handle: RePEc:kap:revdev:v:17:y:2014:i:1:p:39-78
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