Expected loss and fair value over the credit cycle

Daniel Philps and Solomon Peters

Journal of Credit Risk

Abstract: ABSTRACT We present an easily applied method of risk-adjusting reduced-form models for changes in systematic risk over the credit cycle. Using an empirical approach, we model the probable changes in systematic risk over time, showing that investment-grade portfolios that are naive to changes in levels of systematic risk can significantly underestimate expected losses. We build a valuation model that risk-adjusts credit spreads for probable future levels of systematic risk. The model is used to construct lowturnover portfolios, and it is shown to outperform both a naive approach and also the Global Lehman Credit Index for the period 1981–2003.

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