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What is the Connection Between Market and Credit Risk?

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  • Written By: John Lister
  • Edited By: Kristen Osborne
  • Last Modified Date: 26 November 2016
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The connection between market and credit risk depends on the definitions of the terms, which are not firmly fixed. Market risk refers to the potential factors that can affect the overall value of a portfolio of investments. Usually, these are broken down into commodity, currency, equity and interest risks. Credit risk can be defined either as all risks faced by an investor that involve credit, or merely the specific risk of a borrower defaulting. Depending on the definition of credit risk, it is possible for market and credit risk to be counterparts, or for market risk to be an element of credit risk.

There are four main components to market risk. The currency risk is that foreign exchange rates will change in a way unfavorable to the investor. The commodity risk is that commodity prices will change in a way that is unfavorable to the investor. In both cases, there is also a risk that price volatility will increase. This makes investments such as options contracts more unpredictable, which in turn makes them less attractive to investors and thus may reduce their market value.

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The third risk is equity risk, the risk that the price or volatility of investments such as stock will change in a way unfavorable to the investor. The final risk, interest risk, is that prevailing interest rates will change. This can negatively affect an investor; for example, if rates increase overall, a fixed rate bond becomes less attractive to investors, which can drive down its resale value.

Credit risk is less clearly defined, which is why the relationship between market and credit risk can be disputed. One definition is that credit risk is all risks that involve a borrower failing to make agreed repayments. With some types of investment, this has an immediate effect on the investor. For example, if a corporation defaults on a bond, the bondholder does not get the money he expected. With others, it is a knock-on effect; for example, if a mortgage-holder whose policy has been sold on as part of a collateralized debt obligation defaults, the market value of that CDO is reduced.

With this definition of credit risk, market and credit risk are two separate sets of risk facing investors. They will interact to some degree as rising levels of defaults will have a knock-on effect on all financial markets. But the two risks are not indivisible. A stock investor will face market risk but may have no direct exposure to credit risk.

In an alternative definition, credit risk refers to all forms of risk facing investors. Market risk thus becomes one element of credit risk using this terminology. In these circumstances, risks related to repayments are usually referred to as default risks, which are classed as another element of the wider credit risk.

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