Static and Dynamic Modelling of Credit Default Risk: Tails, Moments, and Calibration

Abstract

Credit risk modelling can take many different approaches. Each method has its strengths and weaknesses and studying a variety of them can help find new ways of performing credit risk analysis. We present here three different models, each classified either as static or dynamic, and structural or reduced-form. The static structural model from Lucas et al. (2000) helps us derive a moment behaviour theorem within the dynamic structural setting of Bush et al. (2011). For comparison, we also present the dynamic reduced-form model of Giesecke et al. (2012). A calibration exercise of the dynamic structural model is implemented and we study its performance through changing financial environment. This highlights the horse race between simplicity and efficiency of a model that still needs to be adequately addressed, as the results from the calibration show the difficulty of capturing the key financial environment’s aspects.