Structured and Reduced Form models

Hi. I read a few posts & the Kaplan notes regarding these models within the credit analysis section.

I don’t think I quite understand:

  • What is the final goal of these models? I.e., what do they intend to “output” ?

I think I get the idea that a firm’s balance sheet can be viewed as equity & option, etc., but don’t understand the ultimate goal, so any help would be very appreciated.

In terms of credit analysis, the goal of both structural and reduced form models is to analyze the credit risk. What is the probability of default? What is the loss given default? What is the size of the expected loss?

They just go about it in 2 different ways. Structural models assume you have a lot of detailed information and your default time is known. Structural models use an economic model and are based on economic theory. They are fairly intensive and difficult compared to reduced form models (which seek to estimate the same thing but use a less rigorous approach).

Reduced form models assume you don’t have a detailed level of information to work from, and you don’t know your default time. They are not based solely on a fixed economic model or theory, instead they are based on what could work empirically and can be based on intuition. Then econometrics are used to estimate the equation for the model.