What is credit risk?
Credit risk is the risk that a borrower will not repay a loan or other debt obligation. This can result in a financial loss for the lender, who may not receive the full amount of principal and interest that is owed.
What are the different types of credit risk?
There are many different types of credit risk, but some of the most common include:
- Default risk: This is the risk that a borrower will not make any payments on a loan.
- Concentration risk: This is the risk that a lender has too much exposure to a single borrower or industry.
- Country risk: This is the risk that a borrower in a particular country will not be able to repay a loan due to economic or political instability.
- Downgrade risk: This is the risk that a borrower’s credit rating will be lowered, which could make it more difficult or expensive for them to borrow money.
- Institutional risk: This is the risk that a lender will not be able to repay its debts due to financial problems.
What causes credit risk?
There are many factors that can cause credit risk, including:
- The borrower’s financial situation: If a borrower has a low income or a lot of debt, they are more likely to default on a loan.
- The borrower’s credit history: If a borrower has a history of making late payments or defaulting on loans, they are more likely to do so in the future.
- The economic environment: If the economy is in a recession, borrowers are more likely to default on loans.
- Changes in interest rates: If interest rates rise, it can make it more difficult for borrowers to repay their loans.
How is credit risk managed?
There are a number of ways to manage credit risk, including:
- Lending to borrowers with good credit history: Lenders can reduce their risk by lending to borrowers with a good credit history.
- Requiring collateral: Lenders can require borrowers to provide collateral, such as a car or house, that can be seized if the borrower defaults on the loan.
- Setting interest rates: Lenders can set higher interest rates for borrowers with higher credit risk.
- Insuring against losses: Lenders can purchase insurance against losses due to credit risk.
Multiple choice questions:
- Which of the following is NOT a type of credit risk?
- Default risk
- Concentration risk
- Country risk
- Downgrade risk
- Institutional risk
- The answer is Institutional risk. Institutional risk is not a type of credit risk, but rather a type of financial risk.
- Which of the following factors is NOT a cause of credit risk?
- The borrower’s financial situation
- The borrower’s credit history
- The economic environment
- Changes in interest rates
- The borrower’s age
- The answer is The borrower’s age. The borrower’s age is not a factor that can cause credit risk.
- Which of the following is the best way to manage credit risk?
- Lending to borrowers with good credit history
- Requiring collateral
- Setting higher interest rates for borrowers with higher credit risk
- Insuring against losses
- All of the above
- The answer is All of the above. All of the above are good ways to manage credit risk.