Credit Risk

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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.

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BREAKING DOWN '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.

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RELATED FAQS
  1. What forms of debt security are available for the average investor?

    Common types of debt securities available to the average investor include U.S. Treasury securities, corporate bonds and municipal ... Read Full Answer >>
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    Some investors use credit risk in analyzing individual stocks to determine whether a company might be in danger of defaulting ... Read Full Answer >>
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    The word "capital" has many different meanings in economics and finance. Financial capital most commonly refers to assets ... Read Full Answer >>
  4. 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 >>
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    Liquidity risk has different meanings in different contexts. In investing terms, bondholders face varying liquidity risks ... Read Full Answer >>
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