reduced / structural model

CFA Level II
#1

Can anyone talk me through these two statements in plain english?

  1. Under the reduced form model with constant default probability and constant default intensity, the PV of expected loss will always be less than the expected loss.

  2. Under the sructural model, the PV of expected loss can be greater or less than the expected loss.

#2

  1. yes when you discount the expected loss, it will be lower than the expected loss itself

  2. this is not really a one sentence answer, you need to understand the structural model itself to understand the statement you wrote. (which I will attempt to explain in as basic terms as possible below).

So the structural model is balance sheet driven. Which means a couple things. First off I think it helps to view each stakeholder separately, one stakeholder being the equity holder, the other being the debt holder.

Lets look at equity holder first. The structural model says that the equity holder has a call option on the assets. To understand this, remember the finance 101 fact that in a liquidation scenario debt holders get paid first, then the equity holders. So, if the assets are worth more than the debt, the option gets excercised because the assets that are growing in value are worth more to the equity holders who would rather "excercise the call" and benefit from holding the assets.

In the second scenario, if the assets are worth less than the debt, then the call on the assets expires worthless and the debtors are stuck with the remaining assets and are paid pennies on the dollar.

If you look at this same logic from the point of view of the debt holders, they are in essence selling a put option on the assets.

This is why the PV of the expected losses can be either greater or less than the expected loss itself.

I just read what I wrote, and I can see how this can definitely be confusing if you don’t have much experience working in restructuring or a similar group, I think CFAI used 3-4 pages on this same info, so I tried to make it as easy to understand as possible, I really hope it helps, let me know if you have questions regarding any details, ill try to see what I can do.