Fintech Reach

Module 9:
Credit Risk

1. Module Overview

This module introduces credit risk, the risk that a borrower will fail to meet its financial obligations. It explains how credit risk is measured, managed, and mitigated using financial tools and strategies.

2. Learning Objectives

By the end of this module, you will be able to:

Understand what credit risk is and where it arises
Identify key components of credit risk
Explain how institutions measure and manage credit risk
Understand the role of credit derivatives

3. What Is Credit Risk

Definition:
Credit risk is the possibility that a borrower will default on a loan or fail to meet contractual obligations.

Key idea:

Credit risk = Risk of not getting paid

4. Types of Credit Risk

4.1 Default Risk

Borrower fails to repay principal or interest

4.2 Credit Spread Risk

Changes in perceived credit quality affect asset prices

4.3 Downgrade Risk

Credit rating is lowered, increasing borrowing cost

4.4 Counterparty Risk

The other party in a financial contract fails to perform

5. Key Components of Credit Risk

Credit Risk = Probability of Default (PD)
            × Loss Given Default (LGD)
            × Exposure at Default (EAD)

Meaning:

PD → likelihood of default
LGD → how much is lost if default occurs
EAD → total exposure at time of default

6. Simple Credit Risk Diagram

Loan Issued → Borrower Behavior → Possible Default                
              ↓
        Loss Depends On:
         (PD, LGD, EAD)

7. Measuring Credit Risk

7.1 Credit Ratings

Provided by agencies (e.g., AAA, BBB, etc.)
Reflect borrower’s creditworthiness

7.2 Credit Spreads

Difference between risky and risk-free interest rates

Higher Risk → Higher Interest Rate → Wider Spread

7.3 Internal Risk Models

Banks use statistical models to estimate PD, LGD, and EAD

8. Managing Credit Risk

8.1 Diversification

Spread exposure across different borrowers

8.2 Collateral

Secure loans with assets

8.3 Credit Limits

Restrict exposure to a single borrower

8.4 Monitoring and Review

Continuous assessment of borrower’s financial health

9. Credit Derivatives

9.1 What Are Credit Derivatives

Financial instruments used to transfer credit risk.

9.2 Credit Default Swap (CDS)

Buyer Pays Premium → Seller Provides ProtectionIf Default Occurs → Seller Compensates Buyer