Credit analysis models

Credit analysis models are used to analyze corporate credit risk. There are two kinds of credit analysis models, structural models and reduced-form models. Whereas structural models are based on the structure of a company’s balance and rely on option theory, reduced form models do not.

Credit-Risk-Analysis

On this page, we discuss both structural models of credit risk and reduced form models of credit risk. We discuss the option analogy that is used in structural models and the reduced form statistical models that underpin reduced form models

Structural model credit risk analysis

Structural models rely on insights provided by option pricing theory. In particular, the models start from the insight that equity is very much like a call option on the company’s assets. The strike price is equal to face value of the debt. 

  • If, at maturity, the value of the company is higher than the face value of the debt, then shareholders will exercise their call option to acquire the assets.
  • If, however, the value of the company’s assets is less than the face value of the debt, then the shareholders will let the option expire. This will leave the company’s assets to the debtholders.

The structural model formula is the following

    $$ \textrm{value of equity} = max(0,A_T - K)  $$

    $$ \textrm{value of debt} = A_t - max(0,A_T - K) $$

where A is the value of the company’s assets at time T and K is the face value of the debt.

Advantages structural models

Structural models for credit risk analysis have a couple of advantages:

  • They provide an economic rationale for default and explain why it occurs
  • They make use of option pricing theory to value the debt

At the same time, we should also mention some of the disadvantages of structural models:

  • They assume a simple balance sheet and cannot handle complex balance sheets
  • They assume the assets of the company are traded in the market

Reduced form model credit risk analysis

Reduced form models don’t look at the balance sheet nor do they assume the assets trade in the market. Instead, these models model default as an exogenous variable. That is, they do not explain why default occurs.

Reduced form model require the analyst to specify the default intensity. The default intensity is the probability of default over the next time increment. Default intensity can be estimated using fundamental or macroeconomic regression models. 

Reduced form model advantages

The advantages of reduced form models are that they

  • Do no assume the assets of the company trade (unlike structural models)
  • Allow the default intensity to vary

The disadvantages of reduced form models

  • They do not explain why default occurs
  • Default is treated as a random event, while in practice a default is rarely a surprise

Summary

We discussed the two dominant types of credit risk analysis models; reduced form models and structural models. Both methods have their advantages and disadvantages and both are commonly used by analysts.

The above topic is related to the following set of topics: