Credit risk definition
Credit risk, also known as credit exposure, is the risk of a borrower defaulting on required payments, resulting in a loss to the lender. Credit risk is a principal factor in determining the interest rate on a loan: the higher the perceived credit risk, the higher the rate of interest a lender will demand.
Credit risk is calculated based on the borrower’s ability to repay. It takes into account their collateral assets, their ability to generate revenue and their taxing authority. Time is also accounted for, with a longer-term loan usually indicating a higher credit risk.
Credit risk is a core component of fixed-income investments, as the yields of bonds are closely connected to the perceived risks. That’s why ratings agencies, such as Moody’s and Fitch, continuously evaluate the credit risks of thousands of issuers.