The Jarrow–Turnbull model is a widely used "reduced-form" credit risk model. It was published in 1995 by Robert A. Jarrow and Stuart Turnbull.[1] Under the model, which returns the corporate's probability of default, bankruptcy is modeled as a statistical process. The model extends the reduced-form model of Merton (1976) [2] to a random interest rates framework.
Reduced-form models are an approach to credit risk modeling that contrasts sharply with "structural credit models", the best known of which is the Merton model. Essentially, reduced-form models focus on modeling the probability of default as a statistical process, whereas structural-models inhere a microeconomic model of the firm's capital structure, deriving the (single-period) probability of default from the random variation in the (unobservable) value of the firm's assets. [3]
Large financial institutions employ default models of both the structural and reduced-form types. The Merton structural default probabilities were first offered by KMV LLC in the early 1990s. KMV LLC was acquired by Moody's Investors Service in 2002. Kamakura Corporation, where Robert Jarrow serves as director of research, has offered both structural and reduced-form default probabilities on public companies since 2002.
See also
- Credit default swap
- Credit derivatives
- Credit risk
- Merton model
- Probability of default
- Robert A. Jarrow
References
- ^ Robert A. Jarrow and Stuart Turnbull, "Pricing Derivatives on Financial Securities Subject to Credit Risk" Journal of Finance, vol. 50, March, 1995
- ^ Robert Merton, “Option Pricing When Underlying Stock Returns are Discontinuous” Journal of Financial Economics, 3, January–March, 1976, pp. 125–44.
- ^ Robert C. Merton “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” Journal of Finance 29, 1974, pp. 449–470
Further reading
- Duffie, Darrell; Kenneth J. Singleton (2003). Credit Risk: Pricing, Measurement, and Management. Princeton University Press.
- Jarrow, Robert, Donald R. van Deventer, Li Li, and Mark Mesler (2006). Kamakura Risk Information Services Technical Guide, Version 4.1. Kamakura Corporation.
- Lando, David (2004). Credit Risk Modeling: Theory and Applications. Princeton University Press. ISBN 978-0-691-08929-4.
- van Deventer; Donald R.; Kenji Imai; Mark Mesler (2004). Advanced Financial Risk Management: Tools & Techniques for Integrated Credit Risk and Interest Rate Risk Modeling. John Wiley. ISBN 978-0-470-82126-8.