Credit Risk
What is Credit Risk?
Credit risk is the risk that a borrower fails to repay a loan or bond, causing the lender to lose principal or interest.
It is the core risk banks and bondholders bear: the chance an obligor defaults. Lenders price credit risk by charging higher interest to riskier borrowers, the default risk premium, and by checking credit ratings. Credit risk is distinct from interest-rate risk (rates moving) and liquidity risk (can't sell or fund quickly).
Credit Risk: a worked example
Ridgeline Foods wants to borrow for one year. The safe one-year rate is 4%. A lender judges a 5% chance of default and expects to recover 40% of the promised payment in that case, so expected repayment is 0.95 + 0.05 x 0.40 = 0.97 of whatever is promised. To earn 4% in expectation, the promised rate r must satisfy 0.97 x (1 + r) = 1.04, giving 1 + r = 1.0722 and r of about 7.2%. The default risk premium is 7.2% - 4% = 3.2 percentage points, and the lender's expected return is still 4%.
The mistake students make with credit risk
The tempting error is reading a high yield as a high expected return. A bond promising 7.2% when the safe rate is 4% is not handing over 3.2 free points; that spread is priced to cover the chance of default and partial recovery, leaving an expected return close to 4%. Investors who chase the highest advertised yields are collecting risk, not skill. The promised coupon is printed on the contract while the loss is only probabilistic, which is why the stated number feels more real than the discount for it.
Credit Risk questions
What is the difference between credit risk and interest rate risk?
Credit risk is the chance the borrower does not pay, while interest rate risk is the chance market rates move and reprice a bond you already hold. A default destroys principal; a rate rise only lowers the bond's market price while the scheduled payments continue. A government bond issued in its own currency carries almost no credit risk yet plenty of interest rate risk, which shows the two are separate exposures.
How do lenders price credit risk?
Lenders price credit risk by adding a default risk premium on top of the risk-free rate, sized to the probability of default and how much would be recovered afterward. A borrower with a 2% default chance and 50% recovery loses lenders about 1 cent per dollar promised, while a 10% chance with no recovery loses 10 cents, so the second borrower pays a far larger premium. Credit ratings, collateral requirements and loan covenants are the other levers that shape the final rate.
Can credit risk be eliminated?
Credit risk can be reduced but never eliminated. Collateral, diversification across unrelated borrowers, credit insurance and shorter loan terms all cut expected losses, though each one costs something that shows up as a lower yield. Diversification also weakens just when it is needed, since a downturn pushes many borrowers toward default at once, which is why bank capital exists as the final buffer.
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