115 CFA
File: Fixed Income - Reading 47 - 1. Credit Risk

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.

  • CFA