Credit Risk

Credit risk is the possibility that a borrower will fail to repay their debt obligations, either by missing interest payments or defaulting entirely. Credit risk affects lenders, bondholders, and investors, as it represents the potential for financial loss. Factors that influence credit risk include the borrower’s financial health, credit history, and economic conditions. Managing credit risk is essential for financial institutions and investors to ensure they are adequately compensated for the risk of lending.

Example

A bank assesses the credit risk of a small business applying for a loan by evaluating its credit score, cash flow, and financial statements to determine the likelihood of repayment.

Key points

• Credit risk is the risk that a borrower will default on their debt obligations.

• It affects lenders, bondholders, and investors, leading to potential financial losses.

• Factors influencing credit risk include financial health, credit history, and economic conditions.

Quick Answers to Curious Questions

What factors contribute to credit risk?

Credit risk is influenced by factors such as the borrower’s financial health, credit history, industry, and broader economic conditions.

How do lenders manage credit risk?

Lenders manage credit risk through credit analysis, collateral requirements, and setting interest rates that compensate for the level of risk.

What is an example of credit risk?

A bank faces credit risk when lending money to a company with a poor credit history, as there is a higher chance the company might default on its payments.