Meaning and definition of Credit Risk
Credit risk refers to the risk of loss of principal or loss of a pecuniary reward stemming from a borrower’s failure in repaying a loan or else wise meet a contractual debt. Credit risk arises every time a borrower is looking ahead to use future cash flows through the payment of a current obligation. The investors are rewarded for presuming credit risk through the way of interest payments from the issuer or borrower of a debt contract.
Besides, credit risk is related closely to an investment’s potential return, the most noteworthy being that the yields on bonds correlate strongly to their supposed credit risk. A higher credit risk reflects a higher interest rate demanded by the investors for lending their capital.
Types of Credit Risk
There are, generally, three types of credit risk:
- Credit spread risk occurring due to volatility in the difference between investments’ interest rates and the risk free return rate.
- Default risk arising when the borrower is not able to make contractual payments.
- Downgrade risk resulting from the downgrades in the risk rating of an issuer.
Calculating Credit Risk
Credit risk is calculated on the basis of the overall ability of the buyer to repay the loan. This calculation takes into account the borrowers’ revenue-generating ability, collateral assets, and taxing authority (like government and municipal bonds).
The credit risk is calculated in the following manner:
- Estimate the FICO score of the consumer. The FICO score is a quantifying measure which helps in determining the creditworthiness of an individual as well as his repayment history. Where on one hand, the FICO score indicates the manner in which an individual repays his debt; on the other hand, it does not ensure the repayment in future.
- Calculate the debt-to-income ratio. This is determined by the monthly recurring debts of a company divided by the gross monthly income. Individuals with a debt-to-income ratio below 35% are considered as acceptable credit risks.
- Factor in the potential debt of the borrower. Potential debt refers to the debt which can be taken on by an individual on the basis of his credit card balances and general creditworthiness for obtaining new credit lines.