Default Risk
Default risk is the risk that a borrower will not be able to make payments on a loan or other financial obligation. It is the risk that a borrower will default on a loan, meaning they will not be able to make the payments required by the loan agreement. Default risk is a major factor in the decision-making process for lenders, as it can have a significant impact on their bottom line. Default risk is also a major factor in the pricing of loans and other financial instruments.
History of Default Risk
Default risk has been a factor in lending since the earliest days of banking. As banks began to lend money to borrowers, they had to consider the risk that the borrower would not be able to repay the loan. This risk was often mitigated by requiring collateral, such as a house or other property, to be pledged as security for the loan. As banking and lending evolved, so did the methods used to mitigate default risk.
Today, default risk is managed through a variety of methods, including credit scoring, collateral requirements, and loan covenants. Credit scoring is a system used to assess the creditworthiness of a borrower, and is used to determine the likelihood of a borrower defaulting on a loan. Collateral requirements are used to ensure that the lender has some form of security in the event of a default. Loan covenants are agreements between the lender and the borrower that specify certain conditions that must be met in order for the loan to remain in good standing.
Table of Comparisons
| Risk Type | Default Risk | Interest Rate Risk | Market Risk |
|---|---|---|---|
| Definition | The risk that a borrower will not be able to make payments on a loan or other financial obligation. | The risk that changes in interest rates will adversely affect the value of a financial instrument. | The risk that changes in market conditions will adversely affect the value of a financial instrument. |
| Mitigation | Credit scoring, collateral requirements, loan covenants. | Interest rate swaps, futures contracts, options. | Diversification, hedging, stop-loss orders. |
Summary
Default risk is the risk that a borrower will not be able to make payments on a loan or other financial obligation. It is a major factor in the decision-making process for lenders, and is managed through a variety of methods, including credit scoring, collateral requirements, and loan covenants. For more information about default risk, you can visit websites such as Investopedia, The Balance, and Bankrate.
See Also
- Credit Risk
- Interest Rate Risk
- Market Risk
- Liquidity Risk
- Operational Risk
- Reputational Risk
- Systemic Risk
- Political Risk
- Currency Risk
- Volatility Risk
