What is the motivation for the development of incomplete information credit risk models
What will be an ideal response?
The motivation for the development of incomplete information credit risk models is the belief that both structural and reduced-form models suffer from using incorrect information in their models. Not only that but the information used can even be manipulated by corporations. More details are provided below.
In both structural and reduced-form models, no consideration is given to the fact that the information that investors use may be imperfect. In structural models, for example, firm value is based on the market evaluating correctly the value of the corporation. This could be due to
off-balance sheet derivatives, lease financing, pension obligations, and other factors, all being based on generally accepted accounting principles but not reflecting a true economic state. Moreover, corporate scandals such as that of Enron, Tyco, WorldCom, and Parmalat are constant reminders that the financial information provided by corporations may be far from reflecting their true economic condition. For example, in first-passage time models, as explained earlier, a default barrier is required. Using the information by Enron,Tyco, and WorldCom would have resulted in misleading default barriers.
Incomplete information models take into account imperfect information reported in financial statements. Although incomplete information models were proffered by several researchers, Giesecke and Goldberg propose a structural/reduced form hybrid model based on incomplete information. Their model, which is used by MSCI Barra, is a first-passage time model wherein it is assumed that investors do not know the default barrier. The approach allows a portfolio manager or credit analyst to include her or his view on the financial well-being of a company in calibrating the model-to-market data.
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