Credit risk is the potential for default in a debt investment or credit extension. Lenders and investors must assess the risk before making any transaction. The lender has credit risk when lending money, while the buyer assumes credit risk when purchasing bonds. It is important to explore relevant factors before assuming any credit risk to avoid significant losses.
A credit risk is the amount of default potential that is inherent in a given debt investment or credit extension. A lender or an investor in various types of bonds carries a certain credit risk in any transaction made. Assessing the degree of risk involved is essential before completing any type of loan or investment transaction.
In the case of lending money, the entity that provides the loan has the credit risk. For this reason, a lender will want to know pertinent information regarding the borrower’s ability to repay the loan amount, including all related finance charges and fees. If the lender cannot determine that the borrower will be able to repay the loan, the borrower may be considered a poor risk and may be denied.
With the purchase of bond issues, it is the buyer who assumes a certain degree of credit risk. Bonds generally carry a commitment by the bond issuer to provide the buyer with a full refund of the purchase price of the bond at some future time. As part of the transaction, the buyer also anticipates some type of dividend or interest payment in exchange for the purchase of the bond. If it is not probable that the issuer of the bond will be able to pay the principal or provide interest payments as described in the terms of the bond, the issuer is considered to be risk deficient.
Almost any type of transaction that involves the extension of credit in some way carries some credit risk. In many cases, the level of risk is very low and therefore considered acceptable. At the same time, it is important to explore all relevant factors before assuming any degree of credit risk. Failure to do so may result in a loss to a bond lender or investor that may be significant.
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