Links to all tutorial articles (same as those on the Exam pages)The structural approach to credit risk
This is the third of five articles covering credit risk  this one addresses the 'structural approach'. The CreditMetrics approach treats all issuers in a particular rating class as the same without considering the unique financial characteristics (such as recovery rates) for each issuer. The rating itself is a synonym for default rates, ie a particular expected default rate puts an issuer in a particular rating class.
The ‘structural’ approach is markedly different and follows the following argument:
Two key terms in the formula above clarified:
In this model:
This default spread is a function of three predictable things:
Structural approach in action: an exampleConsider a 1 year bond that has a face value of F and a current market price (or PV) of B. Thus the return on the bond is F/B – 1. Now assume the value of the put is P. The put together with the bond constitute a riskfree portfolio. Therefore F/(B+P) – 1 = r, where r is the risk free rate. In the real world, we know F, we know B and we know r. Therefore we can calculate P or the value of the put from this relationship. In reality, what we are saying is that if we know what the current price of a riskfree bond, and the price of our risky bond, then the difference between the two represents the credit risk or the value of the put.
How does any of the above really help in risk management if we can’t really buy a put on the assets of the firm?The answer is that while we can’t buy a put on the assets of the firm, we can construct a ‘synthetic put’ on the same. How?
