What executives should know about structural credit risk models and their limitations: a primer with examples

The global financial crisis has brought to the forefront the need for executives to better understand the uses and limitations of the structural models frequently employed in the valuation and risk management activities of their firms. The mandate to better manage systemic risk exposure, moreover, dovetails in important ways with the aforementioned goal, given recent advances in the use of structural models in the emerging macrofinance literature for quantifying risk transfer between sectors and economies. This article summarizes the basic structural credit risk literature which originated in the work of Merton (1974), highlights several known limitations of such models, along with possible solutions, and discusses the use of structural models in macrofinance, a field that has already begun to generate useful solutions for several multilateral institutions and central banks around the world.