Hedging Credit Risk – A Lucrative Way to Deal with Risk

People who are in the business of lending money or trading debt assets know that credit risk is the number one concern. When we talk about credit risk, we basically are talking about the inability of a debtor to pay back his or her loans. The most basic way to manage credit risk is to do a credit check prior to lending money. In other words, before you decide to loan someone a specific amount, you might analyze his or her annual income, ability to pay back past loans, and his or her plans for how to use a loan. If it seems like lending money with interest can be a valuable investment, you can lend money and assume that he or she will pay it back. In many cases, however, there other, lucrative ways for hedging credit risk.

When lenders begin hedging credit risk, it’s because they have learned what the risk is and are prepared to deal with it should the worst occur, though they also have found that lending money in a specific scenario is too valuable of an investment to turn down. One common way of hedging is to purchase insurance. In other words, you do have to option to purchase protection against risk by paying a monthly fee. Should a debtor default, you are able to collect money from your insurance risk. This is commonly called a derivative, and people in the investment field commonly trade derivatives. Many create complex securities that include underlying assets, some of which are credit derivatives which protect lenders from potential risk.

It also is possible to participate in hedging credit risk by protecting against specific risks. For example, if you are a manufacturing investor, you might find that sociopolitical unrest in a particular region might affect the value of oil, which in turn can cause harm to your investment organization and have a negative impact on its ability to pay back loans. What you can do is purchase credit protection that kicks in the moment unrest occurs in the relevant world region.

While hedging credit risk has been controversial recently, it’s important to remember that when used safely and ethically, this can be a great safety net not only for investors and lenders, but for whole communities. In short, lenders are more likely to lend to debtors when they are able to purchase protection from harmful risk. Remember that there always is risk, but investors need to know how to write this risk into their broader investment strategies.

About Richard Wilson