Fixed Income - Reduced form model

CFA Level II Fixed Income
#1

Reading 45 > LOS e

Reduced form models impose assumptions on the output of a structural model.

What does it mean the output of a structural model???

Below are the assumptions of the structural model:

  1. Company’s assets are traded in a frictionless market with return μ and variance σ2.
  2. The risk-free interest rate (r) is constant.
  3. The company has a simple balance sheet structure

Many thanks!

#2

I can’t recall 100% of this stuff as i studied it few weeks ago…still i will give it a try.

1)I think structural model says that we have only zero coupon debt in our balance sheet,which is quite unrealistic as our balance sheets also have coupon bearing debts and reduced form over comes this limitations.

2)Structural models says that Rf is constant which is again a limitation since we cannot value fixed income debt if Rf is assumed to be constant…Reduced form overcomes this limitation by assuming that Rf is stochastic.

3)Structural models ignores the impact of business cycles on credit risk…which Reduced form incorporates ie it allows credit risk to change with business cycles.

This is all i can recall now.

Thanks.

#3

I got a headache just by looking at reduced form models reading.

Can anyone give a little summary of what we are supposed to know about generally?