Credit risk arises from the failure of one party to fulfill its financial obligations to another party. Some examples of credit risk include

• A debtor fails to pay interest or principal on a loan (bankruptcy risk);

• An obligor or counterparty is downgraded (downgrade risk), indicating an increase in risk that may lead to an immediate loss in value of a credit-linked security; and

• A counterparty to a market trade fails to perform (counterparty risk), including settlement or Herstatt risk.

 

Credit risk is driven by the probability of default of the obligor or counterparty, the exposure amount at the time of default, and the amount that can be recovered in the event of a default. These levers can all be altered by a firm's approach to risk management through factors such as the quality of its borrowers, the structure of the credit instrument (e.g., whether it is heavily collateralized or not), and controls on exposure. The exposure amount is clear with most loans but can be volatile with other kinds of transactions. For example, a derivative transaction may have zero credit risk at the outset because it has no immediate value in the market.

 

However, it can quickly become a major counterparty credit exposure as markets change and the position gains in value. Traditionally, the probability of default of an obligor is assessed through identifying and evaluating a selection of key risk factors. For example, corporate credit risk analysis looks at key financial ratios, industry sectors, etc. Meanwhile, the risk in whole portfolios of credit risk exposures is driven by obligor concentration as well as the relationship between risk factors. The portfolio will be a lot riskier if:

• It has a small number of large loans rather than many smaller loans;

• The returns or default probabilities of the loans are positively correlated (e.g., borrowers are in the same industry or region);

• The exposure amount, probability of default, and loss given default amounts are positively correlated (e.g., when defaults rise, recovery amounts fall). Risk managers use sophisticated credit portfolio models to uncover risk arising from these combinations of risk factors.