Question

Discuss the differences between traditional credit models and structural credit models. Elaborate on the important insights from option pricing theory that underpin the structural model.

Answer 1

Ans ) difference between the Traditional model and structural model :

Traditional model : value credit risk based on historical data .a risky bind price is derived by observing default rates of past losses or downgrade of bond with comparable credit rating and seniority.

Structural model : derive the value of credit risk by analysing the capital structure of the company.basic concept of black sholes Merton model under lines structural credit risk model as well as reduced from credit risk model.

options pricing theory : uses variable ( stock price , volatility , interest rate ) to theoretical value an option .

primary goal of options pricing theory is to calculated the probability that an option will be excercise,or in the money ,at expiration .

Black sholes options pricing theory : original model required five input variables

• Strike price of options
• Current price of stock
• Time of expiration
• Risk free rate
• Volatility

Volatility is not same as historical or realised volatility.currently dividend are often used as sixth input.

mainly black sholes options pricing theory based on structural model.

Four groups of assumption :

1. Rate of return on the risk free assets is constant
2. The instantaneous log return of the risky assets price is assumed to behave as an infinitesimal random walk with constant drift and volatility ,more precisely according to geometric Brownian motion .
3. Risky assets does not pay a dividend .
4. There are no arbitrate opportunity.

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