CFA Level I · CFA Level I Exam · Credit Risk
Which of the following is the most likely limitation of structural credit models relative to reduced-form models?
A key limitation of structural models is that they depend on the value and volatility of the firm's assets, which are not directly observable and must be estimated. Reduced-form models avoid this by using observable inputs.
- AThey cannot link default to a firm's capital structure
- BThey ignore the option-like payoff of equity
- CThey rely on asset values that are not directly observableCorrect
Explanation
Structural models need the market value and volatility of firm assets, which are not directly observed and must be inferred, and assets are not continuously traded. They do link default to capital structure and do use option payoffs, so the other options are incorrect.
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