Credit risk.

Question 1

Three main approaches to modelling credit risk.

Answer 1

• Structural models
• Reduced form models
• Intensity-based models

Question 2

Structural models

Answer 2

• Structural models aim to link default events explicitly to the fortunes of the issuing corporate entity.
• An example of a structural model is the Merton model.

Question 3

Reduced form models

Answer 3

• Reduced form models use observed market statistics rather than specific data relating to the issuing corporate entity.
  The market statistics most commonly used are the credit ratings…
  … issued by credit rating agencies such as Standard and Poor’s and Moody’s.
  The output of such models is a distribution of the time to default.

Question 4

Intensity-based models

Answer 4

• An intensity-based model is a particular type of continuous-time reduced-form model.
• It typically models the “jumps” between different states,…
  … which are usually credit ratings,…
  … using transition intensities.