The Jarrow–Turnbull model is a widely used "reduced-form"
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
model.
It was published in 1995 by
Robert A. Jarrow and
Stuart Turnbull.
Under the model, which returns the corporate's
probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variety ...
,
bankruptcy is modeled as a statistical process.
The model extends the reduced-form model of Merton (1976) to a random interest rates framework.
Reduced-form models are an approach to credit risk modeling that contrasts sharply with "structural credit models",
the best known of which is the
Merton model The Merton model,
developed by Robert C. Merton in 1974, is a widely used credit risk model.
Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
of 1974.
Reduced-form models focus on modeling the probability of default as a statistical process, whereas structural-models inhere a microeconomic model of the firm's
capital structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
, deriving the (single-period) probability of default from the random variation in the (unobservable) value of the firm's assets.
[ Robert C. Merton “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” ''Journal of Finance'' 29, 1974, pp. 449–470]
Large financial institutions employ default models of both the structural and reduced-form types. The Merton structural default probabilities were first offered by
KMV LLC in the early 1990s. KMV LLC was acquired by
Moody's Investors Service
Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides internation ...
in 2002.
See also
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Credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
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Credit derivatives
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Credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
*
Merton model The Merton model,
developed by Robert C. Merton in 1974, is a widely used credit risk model.
Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
*
Probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variety ...
References
Further reading
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{{DEFAULTSORT:Jarrow-Turnbull model
Financial risk modeling
Financial_models
Credit risk