Forecasting Default in the Face of Uncertainty

Sep 1, 2004

In our structural credit model based on incomplete information, investors cannot observe a firm's default barrier.  As a consequence, such a model has both the economic appeal of a structural model and the tractable pricing formulas and empirical plausibility of a reduced-form model.  A comparison of default probability and credit spread forecasts generated by this model and two well-known structural models indicates that it reacts more quickly to new information and, unlike the other two models, it forecasts positive short-term credit spreads.