Closed form

higaurav

New Member
Hi David,

What do we mean by closed form and reduced form as mentioned for many methods. Like BScholes is closed form ...

Pls suggest.

Rgrds
OM
 

David Harper CFA FRM

David Harper CFA FRM
Subscriber
Hi OM,

Very short version, two different sets:

1. Closed form (a.k.a., analytic. Same for our purposes) versus Numerical
2. Structural versus reduced form

Closed form/analytical = we can solve with a formula; e.g., Black-scholes, parametric VaR
Numerical = we cannot use a formula; i.e.,. we must simulate. For example, historical simulation VaR, monte carlo

Classic example: Black-Scholes is closed form (we have a formula) versus binomial (we brute force a simulation in the open lattice)

Structural versus reduced form implies the credit risk models. See credit risk models de Servigny.
Merton model for PD is structural; i.e., based on balance sheet structure (assets, debt), by variable within (endogenous) to the company. And indeed, the merton is "analytic" or closed form, as above.

Reduced form does not explain PD with company-specific variables, no cause-and-effect to expain the default. Is in "actuarial" model; e.g., CreditRisk+

David
 
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