What do Structural Models assess when estimating default risk?

Structural models primarily assess borrower-specific characteristics when estimating default risk. These models are rooted in the foundational work of Merton, who proposed that a firm's equity can be viewed as a call option on its assets. In this framework, default occurs when the value of the firm's assets falls below a certain threshold, typically the value of its liabilities.

By focusing on borrower-specific characteristics, structural models take into account the inherent financial health and risk profile of the borrowing entity. This includes examining factors such as asset volatility, leverage (the ratio of debt to equity), and the overall capital structure of the firm. These specific attributes help in determining the likelihood of default based on the firm's ability to meet its obligations, regardless of broader economic conditions or market trends.

Well-defined borrower characteristics provide crucial insights into potential future performances, making this approach more nuanced and tailored to individual borrowers compared to other options that focus on broader economic influences or historical performance.