Credit Models: Implicit estimation

CFA Level II Fixed Income
#1

According to the curriculum:

Pg 405 of CFAI Text - Implicit estimation is only method for Structure Models

Pg 412 of CFAI Text - Implicit estimation and historical estimation can be used in Reduced Form Models

However FI Topic Test #7 (Seacrest) has this excerpt:

Marlin asks Betta if reduced-form models of corporate credit risk provide advantages over structural models. Betta responds that reduced-form models have less restrictive assumptions than structural models because of the one critical assumption that cannot be relaxed. He notes two weaknesses with regard to reduced-form models: (1) The use of past observations to predict the future require that it be formulated and back tested properly, and (2) credit risk measures are biased by implicit estimation procedures.

Question: Which comment made by Betta is least likely correct with regard to reduced-form models relative to structural models?

Answer: Betta is incorrect in his comment about the second weakness of reduced-form models. It is a weakness of structural models because their credit risk measures are biased because implicit estimation procedures inherit errors in the model’s formulation.

Per the text, Reduced Form models can ALSO have biased implicit estimation procedures. How is statement 2 incorrect? Is it because Reduced Form Models have two options (historical & implicit) and you can choose the non-biased estimate? I don’t like some of these answers.

#2

implicit estimation is the ONLY method available for structural models. So you could make a mistake, never know about it.

in reduced form models - you have both available (implicit estimation and historical estimation) - so the two can corroborate each other. you have more model validation available with reduced form models.

#3

Reduced model can use both implicit and hazard rate estimation. Hence is not biased to any estimation procedure.