Credit Risk

The risk (danger of financial loss) that arises from the possibility that borrowers in ordinary business dealings and counterparties in derivatives transactions may fail to meet their obligations and end up in default. This risk can be quantified using a range of tools such as historical default probabilities, conditional default probabilities (hazard rates), recovery rates, etc. For example, default probabilities can be estimated using bond prices, asset swap spreads (ASW), equity prices, and so on. In the context of derivatives, dealers resort to adding a number of clauses to their contracts to mitigate credit risk, including: netting, collateralization, and downgrade triggers.