Financial Economics

WEB-APPENDIX D

CREDIT RISK

Investors in corporate debt obligations are exposed to credit risk. There are two types of credit risk: default risk and downgrade risk. We discuss each in this appendix. In addition, we discuss instruments that allow for the transfer of credit risk.

D.1 DEFAULT RISK

Default risk is the risk that the issuer will fail to satisfy the terms of an obligation with respect to the timely payment of interest and repayment of the amount borrowed. Large institutional investors employ specialists (called credit analysts) to carry out credit analysis; however, often it is too costly and time-consuming to assess every issuer in every debt market. Therefore, individual investors rely on analysis performed by nationally recognized statistical rating organizations (popularly referred to as rating agencies) that perform credit analysis of issues and issuers and express their conclusions in the form of a credit rating. The three largest rating agencies are Moody's Investors Service, Standard & Poor's Corporation, and Fitch Ratings.

A credit rating is a formal opinion given by a rating agency of the default risk faced by investing in a particular issue of debt securities. For long-term debt obligations, a credit rating is a forward-looking assessment of the probability of default and the relative magnitude of the loss should a default occur. For short-term debt obligations, a credit rating is a forward-looking assessment of the probability of default. Table D.1 shows the ...