Philps, Daniel and Solomon Peters, "Expected Loss and Fair Value Over the Credit Cycle", Journal of Credit Risk, Vol. 1, No. 2, (Spring 2005), pp. 35-49.
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: Credit risk, credit cycle, reduced form, Global Lehman Aggregate, fair value.