Credit Risk Modeling: A General Framework

The two well-known approaches for credit risk modeling, structural and reduced form approaches, have their advantages and disadvantages. Due to the fundamentally different assumptions of the two approaches, the structural models are used for default prediction that focuses on equity prices and reduced form models are used for credit derivatives pricing that focuses on debt values. In this chapter, via a simple discrete binomial structure, we provide a unified view of the two approaches. In particular, in our formulation, the pricing formulas for risky debts are identical under the two approaches. The two approaches differ in only the recovery assumption. This result makes comparison of various models empirically possible. We demonstrate, in a credit derivative example that is sensitive to the recovery assumption, how different recovery assumptions impact its prices.