
 Unifying Discrete Structural Credit Risk Models and ReducedForm Models by ChoJieh Chen of the University of Waterloo, and July 15, 2002 Summary: In a structural credit risk model, a default event is triggered by the capital structure when the value of the obligor falls below its financial obligation. In a reducedform model, the bond price of a firm is considered as the current value under risk neutral valuation of a contingent claim paying full obligation (of one unit, say) if no default event happens and paying a fraction of promised payment or nothing if a default event happens. With modelspecific assumptions, the bond price can be reduced to the mean of recovery rate and the probability of default for discrete models or an intensity process for continuous models. Based on noarbitrage assumption, we show that the yieldspread formula for a reducedform model is equivalent to a creditspread formula for a structural model if the value of the firm follows a diffusion process or a jumpdiffusion process. If the strong priority rule is applied, the prices of bonds of different seniority classes reflect the distribution function for the jump size and jump frequency. For reducedform models, we shows that the forward credit spread for a RTV scheme can be given by a simple formula which converges to the credit spread for a RMV scheme. Keywords: Default risk, Brownian motion, Jumpdiffusion process, Structural model, Reducedform model. Published in: Insurance: Mathematics and Economics, Vol. 33, No. 2, (October 2003), pp. 357380. Books Referenced in this paper: (what is this?) 