Credit Risk – Knowing the Basics

There are plenty of different types of risk in the financial world, from portfolio risk to liquidity risk.  One of the most important to understand risks is known as credit risk.  There are actually several different types of credit risk out there, and it will have a major impact on nearly all aspect of finances, from basic credit card applications all the way up to major mergers.  Investors and creditors alike need to understand the basics behind this form of risk, especially since it is such a major influence on so many different parts of doing business in the financial world today.

Basically, credit risk refers to the chance of an investor losing funds loaned to a borrower due to default on payment.  It’s often known as default risk for just that reason.  Not only will an investor lose their principal investment amount, they’ll also lose interest funds and may have to pay collection costs in an effort to regain their lost funds.  Most lending groups or investors set up their own credit models that they use for analyzing and assessing credit risk and determine whether or not a loan or investment is worth making.  The most obvious example of this is a credit check used to assess whether or not a customer qualifies for a loan or credit card.

Credit default risk is the most commonly discussed form of credit risk.  This is essentially an assessment made into what the chances are that a customer will repay the loan extended to them.  A number of different factors will be looked at when assessing credit default risk.  Concentration risk is another form worth considering and basically involves a group of risks and whether or not they may trigger losses that are actually large enough to cause serious threats to a bank’s main operations.

If you’re a lender then knowing the amount of credit risk associated with a loan is vital for determining whether or not you can afford to extend the requested funds.  Investors will use this risk similarly to assess things such as bonds or stock investments and whether or not the risk of loss is too great to justify the means.  And even consumers owe it to themselves to understand credit risk since their level of risk will have a major impact on everything from interest rates to principal qualifying amounts.  The basics are easy to grasp but can have very far reaching consequences.

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