Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments

4. Modeling Credit Risk: Alternative Approaches

In Chapter 3, “Modeling Credit Risk: Structural Approach,” we discussed the structural approach to credit risk modeling. We discussed primarily one application of that approach, the Merton model, which also is the main credit risk model used in this book. In practice, however, a wide variety of models are used for pricing and hedging credit risk. You now know that these models can be grouped into three large categories: structural models of default (such as those we covered in Chapter 3), empirical models (also known as credit scoring models), and reduced form models. Whereas the structural approach proposes that firms never default by surprise, and that their default probability can be modeled ...