Jarrow Turnbull Model

Definition of Jarrow Turnbull Model

Jarrow Turnbull Model is the first models for pricing credit risk. It was developed by two people, Robert Jarrow and Stuart Turnbull. This model makes use of multiple factor and complete analysis of interest rates to calculate the probability of default. It is one of the best reduced-forms of model that helps in ascertaining credit risk. The other type of model to ascertain credit risk is structural model.

In the structural model, a modeller, who can be a company’s manager or anyone from the company who has the complete knowledge of the company’s assets and liabilities, and would help in predicting the market in the future. On the other hand, reduced-form of models the modeller would not have any knowledge of any of the company’s assets and liabilities. The ideal method you should use for pricing is the reduced-form of model.

This model makes use of the interest rate to analyze credit pricing. Jarrow Turnbull model is a very valuable model which shows how credit investments made would perform under different rates of interest, where interest is not a constant figure. It is a great tool that a lender can use for their tactics in risk management.

What is Credit Risk?

Credit Risk is the risk of loss due to non-payment of loans by the debtor or no-payment of any other types of debts. The investor can face many types of losses which include loss of interest, decrease in flow of cash, increase in the costs and other such losses. Credit risk is also known as default risk or counter party risk.

The difference between Structural Model and Reduced-Form Model

Structural models provide a link between the credit quality of a firm and the firm’s economic and financial conditions like the Merton’s model. It assumes that the modeler has the same information, set information of the exact information of the assets and liabilities of the company.

Reduced-form models on the other hand make use of the same information which is set based on the market, which is usually incomplete, and a general knowledge about the firm’s condition at a particular time. Both these models are not based on the information which is expected or unreachable but whether this information is applicable to the market or not.

Jarrow Turnbull model was the first type of reduced-form of model for ascertaining credit risk, where bankruptcy of a company is modeled as a statistical process instead of a structural model based on the firm’s capital structure.