Reduction model

A reduction model is a financial model for credit risk that models the credit default of one or more companies and is often used to value credit derivatives . The point of failure is usually defined as the first point in time of a Poisson process . The intensity of the Poisson process is then also called the failure intensity. An important subclass of reduction models are models for the rating of a company, in which the default intensity depends on the changes in the rating.

In contrast to goodwill models, which derive the value of a credit derivative from the goodwill with the help of option price theory , a reduction model derives the credit derivative value from market prices of traded corporate bonds. For this purpose, the failure intensity is adapted as well as possible to the given market prices. Then the disbursements of the credit derivative are evaluated with the help of the determined default intensities.

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• Jarrow, Turnbull: Pricing Derivatives on Financial Securities Subject to Credit Risk, Journal of Finance , 50, 1995, pp. 53-85.
• Duffie, Singleton: Modeling Term Structures of Defaultable Bonds, Review of Financial Studies, 1999, 12, pp. 687-720.