Credit Risk

Lesson

Credit risk, or default risk, is an unsystematic risk that arises when borrowers fail to meet their debt obligations. This can lead to a loss for the lender or investor. Credit risk can be managed through diversification, credit analysis, and credit derivatives.

Practice Question #1

Which of the following is a method to manage credit risk?

A) Investing in a single industry

B) Diversification

C) Ignoring credit ratings

D) Focusing on high-yield bonds

Select an option above to see an explanation here.

A) Investing in a single industry increases concentration risk, not credit risk. B) Diversification helps to reduce credit risk by spreading investments across different borrowers and industries. C) Ignoring credit ratings can lead to higher credit risk, as credit ratings provide information about a borrower's creditworthiness. D) Focusing on high-yield bonds can increase credit risk, as high-yield bonds typically have a higher risk of default.

Terms

Credit risk:: The risk that a borrower will default on their debt obligations
Default:: Failure to meet debt obligations, such as interest or principal payments
Unsystematic risk:: Risk that is specific to a particular company or industry and can be reduced through diversification
Credit rating:: An assessment of a borrower's creditworthiness, usually provided by a credit rating agency
Credit spread:: The difference in yield between a risky bond and a risk-free bond, reflecting the additional risk of the risky bond
Collateral:: Assets pledged by a borrower to secure a loan, which can be seized by the lender in case of default

Practice Question #2

What is the primary difference between credit risk and interest rate risk?

A) Credit risk is systematic, while interest rate risk is unsystematic.

B) Credit risk is the risk of default, while interest rate risk is the risk of changes in interest rates.

C) Credit risk can be eliminated through diversification, while interest rate risk cannot.

D) Credit risk affects only bonds, while interest rate risk affects all investments.

Select an option above to see an explanation here.

A) Credit risk is unsystematic, while interest rate risk is systematic. B) Credit risk is the risk of default, while interest rate risk is the risk of changes in interest rates affecting the value of an investment. C) Both credit and interest rate risks can be managed, but not eliminated, through diversification. D) Credit and interest rate risks can affect various types of investments, not just bonds.

Do Not Confuse With

Systematic risk:: Risk that affects the entire market or economy and cannot be reduced through diversification

Practice Question #3

Which of the following is NOT a factor in evaluating credit risk?

A) Credit rating

B) Credit spread

C) Recovery rate

D) Market sentiment

Select an option above to see an explanation here.

A) Credit rating assesses a borrower's creditworthiness and is a factor in evaluating credit risk. B) Credit spread reflects the additional risk of a risky bond compared to a risk-free bond and is a factor in evaluating credit risk. C) Recovery rate is the percentage of a defaulted debt that can be recovered by the lender and is a factor in evaluating credit risk. D) Market sentiment is related to the overall market and is not a direct factor in evaluating credit risk.

Historical Example

In the 2008 financial crisis, many financial institutions faced significant credit risk due to their exposure to subprime mortgages. As borrowers defaulted on their mortgage payments, the value of mortgage-backed securities declined, leading to significant losses for investors and financial institutions.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

A bank lends money to a small business. The small business needs help generating enough revenue and eventually defaults on loan payments. The bank, as the lender, faces credit risk and may be unable to recover the total amount of the loan.