Expected Loss and Fair Value Over the Credit Cycle
Posted: 25 Apr 2005
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
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