Credit Risk
The risk that a borrower fails to make interest or principal payments as promised.
Formula
Expected Loss = Probability of Default x Loss Given Default x Exposure at Default
Unit
%
In depth
Credit risk is asymmetric in a way that catches lenders out: the best outcome is being repaid exactly as agreed, so the upside is capped at the coupon while the downside is most of the principal. This is why a small increase in default probability requires a large increase in yield to compensate. It affects equity too, since a company that cannot service debt has no residual value for shareholders, which is why bond markets often price distress before equity markets do. Diversification helps, but credit events cluster in downturns, so defaults arrive together rather than independently.
Worked example
A 2% annual default probability with a 60% loss given default gives an expected loss of 0.02 x 0.60 = 1.2% a year. A bond must yield at least 1.2 points above the risk-free rate merely to break even on expected losses.
Illustrative figures, chosen so the arithmetic is easy to follow. Not a live price and not a valuation of any company.
Educational reference only
This entry explains what “Credit Risk” means. It is not investment advice and not a recommendation to buy or sell any security. Any numbers above are illustrative, not live prices, and nothing here predicts price direction or rates a stock. Consider your own circumstances and consult a SEBI-registered investment adviser before acting.