The credit market

Abstract

The credit market can be thought of as that part of the fixed income market where credit quality of the obligor is an important consideration. While US Treasury instruments are a big part of the fixed income market, the fact that the obligor in that market, namely, the US government, is virtually risk free, makes credit risk a nonissue there. However, any bond issued by a corporate bears the risk that the issuer may become delinquent making these instruments sensitive to credit quality of the issuer. Thus, credit risk borne by a lender can be defined as the risk of a decline in the borrower's creditworthiness. This would include the risk of the borrower's outright inability to meet her obligations in a timely manner (which would constitute a default event) or just a decline in the borrower's credit quality (whichwould be realized through a ratings downgrade by a credit rating agencies.) It is well known that bonds are priced as the present value of their cash flow stream. Thus, the inability of a borrower to make a timely payment will impact the timing of the cash flow and hence affect the price of the security. In the worst case, namely, if a borrower is unable to make any scheduled payments, it would lead to significant drop in the price of the bond. From its definition, it is clear that credit risk pervades all financial transactions where some form of credit is extended. As an example, we consider below the type of credit risk faced by type of financial institution. © 2009 Springer-Verlag Berlin Heidelberg.