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Definition: Credit Risk
It is the risk which arises from the uncertainty of a borrower’s ability to perform his contractual obligations. It is a risk of losing the monetary benefits which were supposed to arise from the credit instrument (ex: interest, principal, etc.) because of default made by the borrower in repaying the loan or meeting a contractual obligation. If the credit risk is high, the lender will demand a higher interest rate to compensate for the additional risk taken.
The credit quality of the obligation is analyzed by the lenders through their customized models. Companies also use 3rd party credit ratings such as: Standard & Poor (S&P), Moody’s etc. And based on the quality of credit, appropriate risk management strategies are designed.
In derivative instruments, the credit risk is of 2 types: -
1. Pre-settlement risk: It is the risk of loss due to a counterparty defaulting on a contract during a life of a transaction.
2. Settlement risk: It is the risk of loss due to the counterparty’s failure to perform on its obligation after an institution has performed on its obligation under a contract on the settlement date.