What does credit risk refer to?

Credit risk specifically refers to the risk associated with a borrower’s ability to repay a loan or meet contractual obligations. This is particularly relevant in investments that involve lending money, such as bonds or loans. When an entity, whether an individual or a corporation, borrows money, there is a possibility that they may not be able to fulfill their repayment obligations, either due to financial distress or other issues that affect their cash flow. Hence, if a borrower defaults, the lender incurs a loss, which is fundamentally what credit risk encompasses.

This concept is crucial for investors to understand as it impacts the assessment of potential investments. Lenders often evaluate credit risk through credit ratings, which provide an indication of the likelihood that a borrower will default. The higher the credit risk, the higher the interest rate that lenders typically require to compensate for the increased risk of default.

The other choices refer to different types of risks that investors face. Interest rate risk deals with fluctuations in interest rates affecting the value of investments, particularly fixed-income securities. Market risk captures the potential losses in the stock market due to various factors affecting stock prices. Inflation risk relates to the potential decrease in purchasing power that inflation imposes on returns. Each of these represents a distinct financial risk that investors must consider,