Credit risk measurement and management

Guoqiang Li

4.1 INTRODUCTION

Credit risk is the risk of loss due to default or change in the credit quality of issuers of investment securities, borrowers of funds or counterparties to various transactions. The values of invested assets, loans and other transactions such as derivatives are affected by changes in the credit quality of the issuers, borrowers and counterparties. There are two main risk factors within this category.

1. Default risk. This is the risk that the issuer of the invested asset, the borrower of the funds or the counterparty to the transaction defaults and the investor or lender cannot get the full amount back. For example, the default of Lehman Brothers during the 2007–9 global financial crisis led to significant losses for the many companies that invested in the debts issued by Lehman Brothers or were counterparties to the derivative transactions with Lehman Brothers (Denison et al 2019).

2. Downgrade risk. Also known as rating migration risk, downgrade risk is related to deterioration in the credit quality of issuers, borrowers or counterparties such that the investor suffers a mark-to-market loss. For example, the downgrade of General Electric’s issuer credit rating from AAA