Credit Risk

Reviewed by Vishnava | Updated on Sep 23, 2021

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What Is Credit Risk?

Credit risk is the possibility of a loss happening due to a borrower's failure to repay a loan or to satisfy contractual obligations. Traditionally, it can show the chances that a lender may not accept the owed principal and interest. This ends up in an interruption of cash flows and improved costs for collection.

Excess cash flows can be written to accommodate additional cover for credit risk. When a lender faces increased credit risk, it can be mitigated through a higher coupon rate, which contributes to more significant cash flows.

Understanding Credit Risk

When lenders offer mortgages, credit cards, or any other type of loan, there could be a risk that the borrower might not have the ability to repay the loan. Similarly, if a company extends credit to a customer, there could be a risk that the customer might not pay their invoices. Credit risk also represents the risk that a bond issuer may fail to make a payment when requested, or an insurance company will not be able to pay a claim.

Credit risks are identified based on the borrower's overall likelihood to repay a loan according to the initial terms. Lenders look at the five Cs to assess credit risk - credit history, capacity to repay, the loan's conditions, capital and associated collateral.

Types Of Credit Risks

There are three types of credit risks:

  • Credit spread risk which happens because of the volatility in the difference between investments' interest rates as well as the risk-free return rate.

  • Default risk rises when the borrower is unable to make contractual payments.

  • Downgrade risk emerging from the downgrades in the risk rating of an issuer.

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