Credit Risk

AAA

DEFINITION of 'Credit Risk'

The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.

Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

INVESTOPEDIA EXPLAINS 'Credit Risk'

The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers' overall ability to repay. This calculation includes the borrowers' collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).

Credit risks are a vital component of fixed-income investing, which is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and municipalities on an ongoing basis.

VIDEO

Loading the player...
RELATED TERMS
  1. Allowance For Credit Losses

    An estimation of the debt that a company is unlikely to recover. ...
  2. Financing Squeeze

    A situation in which would-be borrowers find it difficult to ...
  3. Bond Rating

    A grade given to bonds that indicates their credit quality. Private ...
  4. Credit Cliff

    A slang term referring to the compounding of a company's credit ...
  5. Settlement Risk

    The risk that one party will fail to deliver the terms of a contract ...
  6. Gross Debt Service Ratio - GDS

    A debt service measure that financial lenders use as a rule of ...
RELATED FAQS
  1. What is the difference between financial capital and economic capital?

    The word "capital" has many different meanings in economics and finance. Financial capital most commonly refers to assets ... Read Full Answer >>
  2. In what types of financial situations would credit spread risk be applied instead ...

    Default risk and spread risk are the two components of credit risk, which is a type of counterparty risk. Think of default ... Read Full Answer >>
  3. What is liquidity risk?

    Liquidity risk has different meanings in different contexts. In investing terms, bondholders face varying liquidity risks ... Read Full Answer >>
Related Articles
  1. Credit & Loans

    Understanding Credit Risk

    Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt.
  2. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  3. Investing Basics

    What Is A Corporate Credit Rating?

    Is the bond you're buying investment grade, or just junk? Find out how to check the score.
  4. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  5. Credit & Loans

    The Importance Of Your Credit Rating

    A great starting point for learning what a credit score is, how it is calculated and why it is so important.
  6. Insurance

    Basel II Accord To Guard Against Financial Shocks

    Problems with the original accord became evident during the subprime crisis in 2007.
  7. Mutual Funds & ETFs

    ETN Credit Risk May Outweigh Benefits For Some

    Exchange-traded notes have many benefits, but they may not be suited to risk-averse investors.
  8. Forex Strategies

    The 10 Riskiest Investments

    Investors seeking high returns must also be prepared for high risk. Here are ten of the riskiest investments available.
  9. Options & Futures

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  10. Economics

    Understanding Perpetuity

    Perpetuity means without end. In finance, a perpetuity is a flow of money that will be received on a regular basis without a specified ending date.

You May Also Like

Hot Definitions
  1. Fiat Money

    Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat ...
  2. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  3. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
  4. Price-To-Sales Ratio - PSR

    A valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the ...
  5. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  6. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
Trading Center