Credit risk: what it is and how it is calculated

Credit risk is one of the most significant factors in determining prices and returns.
credit risk what it is

Credit risk is one of the most significant factors in determining prices and returns. But it is also the most difficult to quantify. Even if we don’t realize it, we all deal with credit risk on a daily basis.

To understand what credit risk is in finance, let’s start from its definition: It is the risk that the debtor will be unable to meet its interest payment and principal repayment obligations.

This is almost never a remote possibility. Not even when carrying out apparently low-risk financial transactions. For example, the purchase of bonds issued by national governments.

Naturally, the higher the credit risk, the higher the reward for the investment will be, and vice versa. It is important to remember that there are no financial assets that are risk-free.

Credit risk in financial investments

If it is true that every financial operation is characterized by a certain degree of uncertainty, credit risk typically characterizes all so-called lending activities.

In fact, it occurs when the investor, once the maturity has been reached, does not obtain a refund of the invested capital.

The riskiest products from this point of view are naturally debt securities, therefore:

  • treasury bills;
  • government bonds;
  • bonds issued by banking institutions or companies of various kinds.

There are many factors that influence risk. They concern above all the financial solidity of the issuing institutions and companies, their economic prospects and the characteristics of the sectors in which they operate.

To these, of course, there are also market risks. That is to say the possibility that there are substantial variations in prices or in the general trend of the reference market. Conditions that would affect the risk of suffering losses.

In this sense, the best way to secure your assets is to carry out a correct analysis and management of credit risk. More generally, implement appropriate risk management in the composition of your portfolio.

Bank credit risk

To get an overall picture we must not forget the bank credit risk. Bonds issued by credit institutions have historically enjoyed an excellent reputation. It is difficult to imagine that an entire country or a banking giant could fail.

Furthermore, the recent European rules introduced regarding bank rescue provide that public intervention can only be used in extraordinary situations. And that internal resources should be used in the first instance, including the bail-in.

In other words, in the event of default, the losses will fall on the bank’s shareholders and those who hold so-called “subordinated” bonds, i.e. those securities whose payment depends on the satisfaction of other creditors.

The rating

Just as a bank, before granting us a loan or mortgage, processes an assessment of our creditworthiness, in the same way it is possible to evaluate the solvency and reliability of an issuing entity.

The main tool for measuring this type of risk is the rating, which is issued by one or more consultancy companies.

Although these are not official certifications but authoritative assessments, the ratings play a fundamental role. In fact, they state in black and white whether or not a company is able to pay its debts.

The ratings, which are generally expressed in scales of values, are developed taking into consideration both quantitative and qualitative elements, such as:

  • the company’s capital structure, future earnings prospects and the composition of its debt, political and social situation of the country;
  • situation of the relevant market, with a comparison with other similar companies;
  • reliability and the ability of the company’s management to achieve the objectives it has set.

The rating is a useful tool for measuring credit risk not only in the initial phase, i.e. when we are evaluating the opportunity of a given financial product. But also for monitoring the investments over time.

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