CREDIT RISK

Definition

Credit risk is the potential for a financial loss that arises when a borrower or counterparty fails to meet its contractual obligations, such as repaying a loan, bond coupon, or derivative settlement. It is one of the core components of financial risk management and plays a central role in lending, bond valuation, and derivative pricing.

Origins

• "Credit" comes from the Latin creditum, meaning "loan" or "something entrusted."

• "Risk" comes from the Italian risco meaning "danger" or "peril."
  The formal study of credit risk management began in the banking systems of the 18th and 19th centuries, evolving significantly with the rise of modern capital markets and the Basel regulatory frameworks.

Usage

• Banking – Loan defaults and non-performing assets (NPAs).

• Bonds – Risk that issuers fail to make interest or principal payments.

• Derivatives – Risk counterparties fail to settle obligations.

• Trade finance – Importers/exporters failing to pay invoices.

• Consumer finance – Credit card, mortgage, and auto loan defaults.

How Credit Risk Works

1. Lending or transaction occurs – Bank, investor, or seller extends credit.

2. Obligation set – Borrower must repay interest, principal, or settlement value.

3. Default possibility – Borrower may fail to meet obligations due to financial distress.

4. Loss occurs – Lender suffers if the borrower cannot repay and recovery is partial.

Types of Credit Risk

• Default Risk – Borrower fails to repay debt.

• Counterparty Risk – Risk of failure in bilateral contracts (e.g., swaps).

• Concentration Risk – Excessive exposure to a single borrower or sector.

• Sovereign Risk – Governments defaulting on bonds or loans.

Key Takeaway

• Credit risk is inherent in all lending and investing activities.

• It depends on borrower quality, collateral, and macroeconomic factors.

• Proper credit analysis involves quantitative models and qualitative judgment.

• Regulators (Basel III/IV) require banks to hold capital against credit risk exposures.

Context in Financial Modeling

• DCF Valuations – Discount rates include credit spreads.

• Loan Portfolios – Stress testing for default scenarios.

• Bond Pricing – Yields reflect embedded credit risk.

• Capital Allocation – Credit VaR (Value at Risk) models determine required reserves.

Nuances & Complexities

• Asymmetric information – Lenders may misjudge borrower quality.

• Correlation risk – Defaults often cluster in downturns.

• Recovery uncertainty – Legal proceedings affect LGD.

• Market vs. fundamental measures – Credit spreads may reflect sentiment, not fundamentals.

Mathematical Formulas

Expected Loss (EL):

$$EL = PD \times LGD \times EAD$$

Where:

• $PD$ = Probability of Default

• $LGD$ = Loss Given Default (portion of exposure not recovered)

• $EAD$ = Exposure at Default (monetary amount at risk)
  
  

Credit Valuation Adjustment (CVA):

Adjusts derivative prices for counterparty credit risk.

Z-Score Models:

Altman’s Z-score predicts bankruptcy probability using financial ratios.

Related Terms

• Counterparty Risk

• Default

• Probability of Default (PD)

• Credit Spread

• Basel Accords

• Credit Rating

Real-World Applications

Example 1: 2008 Financial Crisis

• Excessive exposure to subprime mortgage credit risk triggered widespread defaults.

Example 2: Sovereign Defaults

• Argentina (2001, 2014) defaulted on sovereign debt, causing investor losses.

Example 3: Corporate Bonds

• Lehman Brothers defaulted in 2008, leaving bondholders with minimal recovery.
  
  
  

References & Sources

• Wall Street Mojo: Credit Risk - Meaning, Example, Types, Modeling, Banks

• Fincart: Understanding Credit Risk: Definition, Types, and More