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Credit Risk Models II: Structural Models

by Abel Elizalde of CEMFI and Universidad Pública de Navarra

April 2006

Abstract: This report reviews the structural approach for credit risk modelling, both considering the case of a single firm and the case with default dependences between firms. In the single firm case, we review the Merton (1974) model and first passage models, examining their main characteristics and extensions. Liquidation process models extend first passage models to account for the possibility of a lengthy liquidation process which might or might not end up in default. Finally, we review structural models with state dependent cash flows (recession vs. expansion) or debt coupons (ratingbased).

The estimation of structural models is addressed, covering the different ways proposed in the literature.

In the second part of the text, we present some approaches to model default
dependences between firms. They account for two types of default correlations: cyclical default correlation and contagion effects. We close the paper with a brief mention of factor models.

The paper pretends to be a guide to the literature, providing a comprehensive list of references and, along the way, suggesting different possible extensions for its future development.

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