Credit Derivatives: A Primer on Credit Risk, Modeling, and Instruments

2. About Credit Risk

In this chapter, we start by discussing what credit actually is and why people and organizations may not live up to their credit engagements. This will help us define credit risk properly. We will then look at the credit risk market, its size, and its origins. We will finally give an overview of the financial instruments available to adjust or mitigate credit risk. These so-called credit derivatives will be covered in detail in Part II, “Credit Risk Modeling,” of this book, but are introduced here for your understanding.

The Building Blocks of Credit Risk

We stated rather cursorily in the introduction that credit risk is “the risk that a borrower won’t pay back the lender.” To fully understand what this means—and to come ...