Introduction to Credit Risk

Abstract

A default risk is a possibility that a counterparty in a financial contract will not fulfill a contractual commitment to meet her/his obligations stated in the contract. If this actually happens, we say that the party defaults, or that the default event occurs. More generally, by a credit risk we mean the risk associated with any kind of credit-linked events, such as: changes in the credit quality (including downgrades or upgrades in credit ratings), variations of credit spreads, and the default event. The spread risk is thus another components of credit risk. To facilitate the analysis of complex agreements, it is important to make a clear distinction between the reference (credit) risk and the counterparty (credit)risk. The first generic term refers to the situation when both parties of a contract are assumed to be default-free, but due to specific features of the contract the credit risk of some reference entity appears to play an essential role in the contract’s settlement. In other words, the reference risk is that part of the contract’s risk, which is associated with the third party; i.e., with the entity, which is not a party in a given agreement. In the present context, the third party is referred to as the reference entity of a given contract. Credit derivatives are recently developed financial instruments that allow market participants to isolate and trade the reference credit risk. The main goal of a credit derivative is to t ransfer the reference risk, either completely or partially, between the counterparties. In most cases, one of the parties can be seen as a buyer of an insurance against the reference risk. Such a party is called the seller of the reference risk; consequently, the party that bears the reference risk is referred to as its buyer.