Explanation:
Structural models (such as the Merton model) are based on the premise that default happens when the value of a firm's assets falls below its liabilities. Thus, the correlation of default is driven by the correlation between the asset values of the firms, which are influenced by common macroeconomic factors.
Reduced-form models, on the other hand, treat default as a random (exogenous) event governed by a hazard rate process (e.g., using a Poisson distribution). They specify default probability and default correlation directly without explicitly relying on the underlying firm's asset values or structural balance sheet mechanics. Therefore, Statement C correctly identifies this distinction.
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Q.26 As part of a complex credit risk management strategy, a financial risk manager needs to explain the distinction between structural and reduced-form models in the context of default correlation models. Which of the following statements accurately describes a feature that differentiates these model types?
A
Structural models focus on the legal framework of default, whereas reduced-form models are based on underlying economic factors that impact a firm's assets.
B
Reduced-form models directly specify default correlation based on asset value, while structural models use statistical concepts like copulas to model dependency structures.
C
Structural models are based on underlying economic factors that impact a firm's assets, with default probability correlated through these factors, while reduced-form models directly specify default correlation without linking to the assets' value.
D
Reduced-form models determine default correlation through the common influences on a portfolio, such as market or sector trends, and structural models do not consider systemic factors.
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