1. Credit Risk

a. describe credit risk and credit-related risks affecting corporate bonds;

## b. describe default probability and loss severity as components of credit risk;

What is credit risk? Credit risk is the risk of loss of interest and/or principal stemming from a borrower’s failure to repay a loan.

What are the two components of credit risk? - Default probability - Loss severity (Loss Given Default (LGD))

What is the formula for Expected Loss? Expected Loss = Default probability X Loss severity

What is a credit spread? The part of the loan risk premium representing the default risk is known as the credit spread.

What two factors could credit risk be on account of? - Downgrade risk - the risk that the issuer will be downgraded, resulting in an increase in the credit spread demanded by the market - Market liquidity risk - the widening of the bid-ask spread on an issuer’s bonds.