On Modeling Economic Default Time: A Reduced-Form Model Approach

TL;DR

This paper develops a reduced-form model to distinguish between economic and recorded default times, aligning more closely with real market observations and improving default risk assessment accuracy.

Contribution

It introduces a novel reduced-form approach to model unobservable firm asset values and default times, extending prior structural models to better reflect empirical default timing data.

Findings

Model captures the difference between economic and recorded default times.

Fits empirical data well, validating the approach.

Provides a probability distribution for default times.

Abstract

In the aftermath of the global financial crisis, much attention has been paid to investigating the appropriateness of the current practice of default risk modeling in banking, finance and insurance industries. A recent empirical study by Guo et al.(2008) shows that the time difference between the economic and recorded default dates has a significant impact on recovery rate estimates. Guo et al.(2011) develop a theoretical structural firm asset value model for a firm default process that embeds the distinction of these two default times. To be more consistent with the practice, in this paper, we assume the market participants cannot observe the firm asset value directly and developed a reduced-form model to characterize the economic and recorded default times. We derive the probability distribution of these two default times. The numerical study on the difference between these two shows that our proposed model can both capture the features and fit the empirical data.