Expected Loss and Fair Value Over the Credit Cycle

Posted: 25 Apr 2005

See all articles by Daniel Philps

Daniel Philps

Mondrian Investment Partners

Solomon Peters

Mondrian Investment Partners

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 low-turnover portfolios, and it is shown to outperform both a naive approach and also the Global Lehman Credit Index for the period 1981-2003.

Keywords: Expected loss, fair value, credit cycle, reduced form model, systematic risk, valuation model, credit spreads

Suggested Citation

Philps, Daniel and Peters, Solomon, Expected Loss and Fair Value Over the Credit Cycle. Available at SSRN: https://ssrn.com/abstract=708021

Daniel Philps (Contact Author)

Mondrian Investment Partners ( email )

80 Cheapside, Third Floor
London EC2V 6EE
United Kingdom

Solomon Peters

Mondrian Investment Partners ( email )

80 Cheapside, Third Floor
London EC2V 6EE
United Kingdom

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