1

2
A credit event is an event that will trigger the
default of a bond. In the event of a default, the
fraction  of the defaulted amount that can be
recovered through bankruptcy proceedings
or some other form of settlement is known as
the recovery rate.

3
 Credit events, which might result in a failure
The outcome of a default may be that the
to meet an obligation (defined for the
contracted payment stream: purposes of credit derivatives), include:
 is rescheduled  actions that are associated with bankruptcy
 is cancelled by the payment of an amount or insolvency laws
which is less than the default-free value of the
ie the bond issuer becomes insolvent.
original contract  downgrade by ‘Nationally Recognised
 continued but at a reduced rate Statistical Rating Organisations’, (NRSROs
such as Moody’s, S&P and Fitch)
 is totally wiped out.
This is of particular concern when a bond is issued
with a guaranteed minimum credit rating.
An example of cancellation would be where
 failure to pay
the bondholders agree to accept a reduced ie either a coupon or the capital amount is not paid
one-off cash payment of 75% of the face value in full and on time.
instead of the contractual payments.  repudiation / moratorium
ie the validity of the contract is disputed or a
temporary suspension of activity is imposed
on the issuer.
 restructuring – when the terms of the
obligation are altered so as to make the new
terms less attractive to the debt holder, such
as a reduction in the interest rate,
rescheduling, change in principal, change in
the level of seniority.

4
5
1. Structural models
These models deliver an explicit link between a
Structural models are explicit models for a
firm’s default and the economic conditions and
corporate entity issuing both equity and debt.
provide a sound basis for estimating default
They aim to link default events explicitly to
correlations amongst different firms. The
the fortunes of the issuing corporate entity.
disadvantage is identifying the correct model
and estimating its parameters.
Structural, or firm-value, models are used to
represent a firm’s assets and liabilities and
These models are called ‘structural’ because
define a mechanism for default.
they focus on the financial structure – the split
Typically, default occurs when a stochastic
between debt and equity – of the company
variable (or process) hits a barrier
issuing the bond.
representing default. The main example of a
structural model is the Merton model.

6
The Merton model
Assume a firm has issued a single zero-coupon
The Merton model is a simple example of a
bond with face value of L which matures at
structural model.
time T.
Debt holders rank above shareholders in the
Classical finance defines the value of a firm
wind-up of a company. So, provided the
F(t) as the sum of its debt, B(t) and equity
company has sufficient funds to pay the debt,
E(t) , so:
the shareholders will receive F(T)-L .
𝐹 𝑡 =𝐵 𝑡 +𝐸 𝑡

Merton’s model assumes that a corporate

entity has issued both equity and debt such
that its total value at time t is F(t). This value
varies over time as a result of actions by the
corporate entity, which does not pay
dividends on its equity or coupons on its
bonds.
The corporate entity will default if the total
For example, the value of a company will
change along with investors’ perceptions of value of its assets, F T  , is less than the
the future prospects of that company. promised debt repayment at time T : i.e.
𝐹(𝑡) < 𝐿
7
In this situation, the bondholders will receive
F(t) instead of L and the shareholders will
receive nothing.
Credit spread is a measure of the excess of the
Combining these two cases, we see that the
yield on a risky security over a risk-free yield. It
shareholders will receive a payoff of
largely relates to the expected cost of default.
max{𝐹 𝑇 − 𝐿, 0}
However, in practice it will also typically reflect
at time T .
other factors, such as a risk premium relating
to the risk of default and a liquidity premium.
This can be regarded as treating the
shareholders of the corporate entity as having
Because of the risk of default, a bond issued by
a European call option on the assets of the
a company will have a lower market price than
company with maturity T and a strike price
a similar bond issued by a government. So the
equal to the value of the debt. The Merton
yield on the company bond will be higher than
model can be used to estimate either the risk-
the yield on the government bond. The credit
neutral probability that the company will
spread refers to the difference between these
default or the credit spread on the debt.
two rates.
Since debt is senior to equity, the value of
equity at maturity:
𝑬 𝑻 = 𝒎𝒂𝒙(𝑭 𝑻 − 𝑳, 𝟎)
and so the value of a firm’s equity is a call
option on the value of the firm with a strike
of the debt.
8
2. Reduced-form models

Reduced-form models do not attempt to Default is no longer tied to the firm value
deliver a representation of a firm, like falling below a threshold-level, as in
structural models do. Rather they are structural models. Rather, default occurs
statistical models that use observed data, according to some exogenous hazard rate
both macro and micro, and so can usually process.
be ‘fitted’ to data.
The market statistics most commonly used These models are called ‘reduced-form’
are the credit ratings issued by NRSROs. because they do not attempt to model the
The credit rating agencies will have used inner financial workings of the particular
detailed data specific to the issuing company issuing the bond. Instead, they
corporate entity when setting their rating. model the different levels of
They will also regularly review the data to creditworthiness and how companies move
ensure that the rating remains appropriate from one status to another.
and will re-rate the bond either up or down
as necessary.

9
3. Intensity-based models

An intensity-based model is a particular

type of continuous-time reduced-form
model. It typically models the jumps
between different states (usually credit
ratings) using transition intensities. The
disadvantage of reduced-form models is
that they sometimes lack the clarity of
structural models.
This approach uses a continuous-time
multiple state model (jump process) where
the states correspond to the
creditworthiness of the company.
The ‘intensities’ (denoted by 𝜆 ) are the
rates driving the company to switch from
one state to another as time passes.
Intensity-based models are an example of
a reduced-form model.

1
0
1
1
1
2
1
3
1
4
Stochastic transition probabilities
The Jarrow-Lando-Turnbull approach assumes An alternative approach would be to
that the transition intensities between states assume that the transition intensity
are deterministic. between states, 𝜆(𝑡), is stochastic and
Although we have allowed the values of the dependent on a separate state variable
transition intensities (t) between any two process U(t).
states to vary over time, we have assumed that By using a stochastic approach, 𝜆(𝑡), can
the functions involved are known with be allowed to vary with company fortunes
certainty at the outset. In real life, however, and other economic factors.
economic conditions can change For example, a rise in interest rates may
unpredictably. If, for example, a recession make default more likely, so U(t) could
struck, we would expect the (t) ’s include appropriate allowance for changes
corresponding to jumps to a higher-numbered in interest rates.
state (ie a state closer to the default State n ) This approach can be used to develop
to increase significantly, as companies models for credit risk that combine the
struggled to remain profitable. structural modelling and intensity-based
approaches.

The process U(t) can be made as complex

as required, generating multi-factor credit-
risk models.

1
5
Given there are 3 credit rating states A,
B, D where D is default. Suppose the
transition probabilities over a one year
interval under a risk-neutral measure
are constant in time. They are given by
the matrix :
0.6 0.1 0.3
෩ = 0.3 0.6 0.1
Π
0 0 1
Find the expression for 𝑉𝐴 0,4 which
describes the value of the zero-coupon
bond with this credit risk profile with
maturity of 𝑇 = 4 years that is
initially 𝐴 rated and which has a
recovery rate 𝛿 and a risk-free rate 𝑟.

1
6
Given there are 3 credit rating states A,
B, D where D is default. Suppose the
transition probabilities over a one year 𝜇 4 =𝜇 0 ෩4 = 𝜇
Π 1 ෩3 = ⋯
Π
interval under a risk-neutral measure
are constant in time. They are given by
the matrix :
∴ 𝑉𝐴 0,4 = 𝑒 −𝑟 4−0
1 − 0.7111 1 − 𝛿
0.6 0.1 0.3
෩ = 0.3 0.6 0.1
Π
0 0 1
Find the expression for 𝑉𝐴 0,4 which
describes the value of the zero-coupon
bond with this credit risk profile with
maturity of 𝑇 = 4 years that is
initially 𝐴 rated and which has a
recovery rate 𝛿 and a risk-free rate 𝑟.

1
7