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even if the distance-to-default – measured by the asset level vs. the default boundary – is
arbitrary high. That is, default can occur at any time.
This result leads to significant differences in the behavior of short-term credit spreads in
the structural vs. reduced-form models. In fact, continuous-time structural models that rely
on a diffusion process for the asset value predict that credit spreads decline to zero as the
maturity goes to zero. The reduced-form models, however, predict that the credit spreads
also remain positive for very short maturities, better reflecting the reality. This feature
makes these latter models the fundamental pricing tool of credit risk and credit derivative
instruments as they can be easily adapted to different market conditions.
Structural models, on the other hand, try to incorporate insights from the corporate finance
literature into a valuation theory of defaultable claims. Hence, their theoretical elegance
contrasts sharply to their empirical quality, even though recent papers have tried to
reconcile the structural and the reduced-form approaches in order to achieve some sort of
advantageous synthesis of the two. 216 Structural models with endogenous defaults provide
a more detailed modeling of the default event, and can improve our understanding of
default reasons and their relations to firm’s financing or risk management decisions. This
latter feature makes the endogenous models a potential tool to quantify and also
qualitatively analyze the impact of corporate risk management on shareholder value.
216 Duffie and Lando [2001] show how credit spreads in structural framework are affected by the often
incomplete (accounting) information available to debtholders. Zhou [2001] assumes that the value of the
firm’s assets follows a jump diffusion process.
205