To start, I’ll say the first assumption of the Structural model
Company assets trade in _ frictionless & arbitrage _ free markets, with a lognormally distributed time T value, and constant returns on assets and volatility.
Next, the first assumption of the reduced form model (the shortened version).
_ Frictionless and arbitrage free _ markets
Now, my frustration is here - according to the CFAI texts, the only model that models risk under the assumption of “liquid” markets, is the structural model. But, how can that not also be the case if markets are frictionless under the reduced form models?
Aren’t there three assumptions to a market being " frictionless"?? 1. No transaction costs 2. Available liquidity, 3. Unlimited borrowing/lending.
Thanks for helping - I’m somewhat puzzled by this. But, come exam day, I’ll gladly just shut up and assume that assets can only be traded in a liquid market under “structural models”.
If I remember well the Structural model makes the assumption that ALL the companys ASSETS trade in frictionless and arbitrage-free markets, where the reduced form model makes the assumption that SOME of the companys DEBT trade in frictionless and arbitrage-free markets. But I can be wrong
Yes, that’s right. The reduced form model only requires that a company’s zero-coupon bond trades in frictionless markets. The other liabilities do not even need to trade under the reduced form model.
For the exam, it’s important to know the differences between the structural and reduced form models. Reduced form models can be complicated mathematically, but you only need to be able to understand qualitatively how they differ from structural form models.
Yes, that’s right. The reduced form model only requires that a company’s zero-coupon bond trades in frictionless markets. The other liabilities do not even need to trade under the reduced form model.
For the exam, it’s important to know the differences between the structural and reduced form models. Reduced form models can be complicated mathematically, but you only need to be able to understand qualitatively how they differ from structural form models.
