Market and credit risk are interconnected but their definitions are not firmly established. Market risk includes foreign exchange, commodity, capital, and interest risks, while credit risk involves the risk of borrower default. The relationship between the two risks depends on the definition of credit risk.
The connection between the market and credit risk depends on the definitions of the terms, which are not firmly established. Market risk refers to potential factors that can affect the overall value of an investment portfolio. These are typically broken down into commodity, currency, principal, and interest risks. Credit risk can be defined as all the risks an investor faces that involve credit, or simply the specific risk of borrower default. Depending on the definition of credit risk, it is possible that market and credit risk are counterparties, or that market risk is an element of credit risk.
There are four main components to market risk. Foreign exchange risk is that exchange rates will change unfavorably for the investor. Commodity risk is that commodity prices will change unfavorably for the investor. In both cases, there is also the risk of increased price volatility. This makes investments such as option contracts more unpredictable, which in turn makes them less attractive to investors and therefore can lower their market value.
The third risk is capital risk, the risk that the price or volatility of investments, such as stocks, will change in a way that is unfavorable to the investor. The final risk, interest risk, is that prevailing interest rates will change. This can negatively affect an investor; For example, if rates generally rise, a fixed-rate bond becomes less attractive to investors, which can reduce its resale value.
Credit risk is less clearly defined, so the relationship between market and credit risk can be disputed. One definition is that credit risk is all risks involving a borrower not making agreed payments. With some types of investment, this has an immediate effect on the investor. For example, if a corporation doesn’t pay a bond, the bondholder doesn’t get the money he expected. With others, it’s a knock-on effect; For example, if a mortgage holder whose policy has been sold as part of a collateralized debt obligation defaults, the market value of that CDO is reduced.
With this definition of credit risk, market and credit risk are two separate sets of risk that investors face. They will interact to some extent, as rising levels of defaults will have a negative effect on all financial markets. But the two risks are not indivisible. A stock investor will face market risk, but may not have direct exposure to credit risk.
In an alternative definition, credit risk refers to all forms of risk that investors face. Market risk thus becomes an element of credit risk using this terminology. In these circumstances, the risks related to repayments are generally referred to as default risks, which are classified as another element of broader credit risk.
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