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. Settlement Risk

    The risk that one party will fail to deliver the terms of a contract ...
  5. Total Debt Service Ratio - TDS

    A debt service measure that financial lenders use as a rule of ...
  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 >>
  4. What are the primary sources of market risk?

    Market risk is the risk of loss due to the factors that affect an entire market or asset class. Market risk is also known ... Read Full Answer >>
  5. How do I learn technical skills for trading commodities?

    Many resources are available for those seeking to learn to trade commodities, also known as futures, directly from the major ... Read Full Answer >>
  6. What techniques can be used for hedging exposure to the electronics sector?

    Hedging exposure to the electronics sector offers an investor a way to insulate his portfolio from losses during periods ... 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. Economics

    What Is Supply?

    Supply is the amount of goods a producer is willing to produce at a given price, and is one of the most basic concepts in economics.
  9. Economics

    Modified Internal Rate of Return (MIRR)

    Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
  10. Investing Basics

    Treasury Inflation-Protected Securities (TIPS)

    Treasury inflation-protected securities are treasury securities that make adjustments for inflation as reflected in the Consumer Price Index.

You May Also Like

Hot Definitions
  1. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  2. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  3. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
  4. Brand Equity

    The value premium that a company realizes from a product with a recognizable name as compared to its generic equivalent. ...
  5. Adverse Selection

    1. The tendency of those in dangerous jobs or high risk lifestyles to get life insurance. 2. A situation where sellers have ...
Trading Center