Credit risk is the risk of loss through a counterparty's inability or failure to meet a financial obligation, or deterioration in its credit quality. A loss model distinguishes credit default frequency from loss given default; shared exposures or systematic factors may produce dependence beyond an independent Poisson model.
In the basic structural model, the firm's asset value follows geometric Brownian motion with constant volatility and a single debt obligation of face value matures at . Default at maturity occurs when . Equity is a call on firm assets; debt is the risk-free face claim minus a put on those assets, since . This links debt valuation to asset value, volatility and capital structure. The basic model does not permit default before maturity; richer structural models add a default barrier or more detailed obligations.
The risk that a trading counterparty defaults while owing a positive replacement value or settlement amount. It differs from the reference borrower's default exposure in a credit default swap. A credit hedge may fail precisely when its protection seller is distressed. Collateral, netting and margining change exposures and loss amounts; they do not turn every mismatched hedge into a risk-free claim.
A yield difference between a credit-risky instrument and a chosen benchmark, with maturity and other terms matched as appropriate. The benchmark and quotation convention must be specified. The spread may compensate for default losses, default-risk premiums, liquidity and other effects; it is not generally identical to a physical default probability or loss rate.
An option with payoff linked to widening or narrowing of a specified credit spread. A simple spread-widening payoff has the displayed form, where is an annuity or settlement scale. This transfers spread-mark-to-market risk and need not require an actual default event. Pricing depends on spread volatility, discounting, default treatment and the settlement convention.
A credit rating is an ordinal assessment of an issuer's or obligation's creditworthiness. Agency scales group credits into broad investment-grade and speculative-grade classes, with default categories and rating transitions. A rating is not itself a calibrated default probability, and identical ratings do not establish independence or constant intensities of defaults.
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Credit risk refers to the possibility that a borrower or counterparty will fail to meet their obligations in accordance with agreed terms, which often results in a financial loss for the lender or investor. This risk is particularly relevant in the context of loans, bonds, and other financial instruments where the repayment of principal and interest depends on the creditworthiness of the borrower.