What is Credit Risk?

What is Credit Risk?

Credit risk refers to a loss suffered by a party whereby the counterparty fails to meet its contractual obligations.
Credit risk may arise if there is an increasing risk of default by the counterparty throughout the duration of the contract.

There are four subtypes of credit risk:

1. Default risk: It refers to potential nonpayment of interest and/or principal on a loan by the borrower. The PD is central to risk management.
2. Bankruptcy risk: It refers to potential nonpayment of interest and/or principal on a loan by the borrower. The PD is central to risk management.
3. Downgrade risk: It considers the decreased creditworthiness of a counterparty. A creditor may subsequently charge the downgraded entity a higher lending rate to compensate for the increased risk. For a creditor, downgrade risk may eventually lead to default risk.
4. Settlement risk: It considers the decreased creditworthiness of a counterparty. A creditor may subsequently charge the downgraded entity a higher lending rate to compensate for the increased risk. For a creditor, downgrade risk may eventually lead to default risk.

Example of Risk

The core operations of a Bank involves lending out money to governments, corporates and individuals. When the Bank lends out money, there is always a possibility the debtor gets default and doesn’t return the money. Here, the risk of not getting the money back is an example of Risk in a financial term.