What is Credit Risk?

What is the meaning and significance of credit risk? Well, the first answer is that credit risk is "a risk that a counter party will fail to meet a contractual payment obligation." An example would be short selling. I borrow $55 to go and buy stock. My bet is that the stock price will fall, allowing me to make a profit. However, if the price increases, I am still obligated to repay the $55 plus interest back to the lender. The chance that I might not be able to repay the lender means they have a level of credit risk. Credit events (situations where credit risk is evident) would be companies declaring bankruptcy or failure to make bond payments. In reference to bond payments, people can use bond ratings to measure the amount of credit risk and the probability a company will default on a bond. The same holds true for estimating the probability of firms going bankrupt. The ratings transition matrix has a host of numbers that helps firms determine the probability that they will go move from one rating category to the next.

One might think, "Lending and borrowing is done everyday, it's a way of life. Since it's hard to really operate with out the two, how does one protect himself from credit risk?" The answer is yes. Just as their are derivatives to help firms hedge from price risk, there are credit derivatives used to transfer credit risk from a firm. One financial structure is called a CDO, collateralized debt obligation. Using a CDO allows one to take a group of risky bonds and create new claims, where some are less risky than the original bonds. Another derivative is a CDS, credit default swap. As mentioned earlier, a default is when a borrower can not repay its debt to the lender. A CDS makes a payment when a firm experiences a credit event, thereby protecting the purchaser (protection buyer) in the event of a default.

Taking all of these things into account, we see that credit risk is more prevalent than we think. In a simple borrow-and-lend exchange amongst friends, their is a level of credit risk there. And even in that case, smart friends would ask for some collateral or promise of something else in case of default. The same way this informal situation shows protecting actions, this is the same manner firms behave when placed in a credit event.

(The information for this posting was read about in previous classes. However, I received more knowledge from the book "Credit Risk. Derivatives Market." by Robert McDonald.)