Companies face various types of risk due to their nature. Therefore, they need an efficient risk management strategy to run successfully. Similarly, investors need to identify these risks before investing in a company’s equity or debt instruments. Among those risks, two risks often occur more, market and credit risk.
What is Credit Risk?
Credit risk represents the risk faced by companies as a result of their credit transactions. Credit risk is most relevant to businesses that offer credit sales or make credit purchases. Credit risk refers to the possibility of losses occurring from a borrower's failure to repay a loan or meet a contractual obligation. Two types of risks come under credit risk for companies.
Firstly, credit risk may refer to a company's customers being unable to pay their credit amounts. In simple words, credit risk represents the risk of bad debts. On the other hand, credit risk can also refer to a company's credit risk with its suppliers. When companies buy or sell products or services through credit, they take a financial risk due to default on payments.
Credit risk also comes with many implications. Most importantly, it disrupts the cash flows of a business and causes losses. Furthermore, while companies can't predict which party will default on payments, they still need to assess and manage their credit risk. Through this, companies can reduce the impact of the credit risk if it realizes.
For investors, credit risks come from a company’s inability to pay or fulfill its contractual obligations. For example, for an investor holding a company's bonds, the credit risk is that the company fails to repay them either through interest or principal amount. Usually, credit risk accompanies all bonds that investors can source from companies.
What is Market Risk?
Market risk refers to the risk of changing conditions in the market in which a company operates. Various types of market risk can influence a company. These include interest rate risk, which comes from volatility occurring due to fluctuations in interest rates. Similarly, it may consist of equity risk, which comes from changes in the prices of stock investments.
For investors, market risk is the possibility that they experience losses due to factors that impact a financial market's overall performance in which they hold investments. Another name commonly used for market risk is systematic risk. These risks influence the whole market rather than specific stock or industry. It is the opposite of systematic risk.
The primary source of market risk is fluctuations in prices or rates. Market risk is calculatable using various techniques such as the Value-at-Risk (VaR) method. Another model used to calculate a portfolio's market risk is Beta, often utilized in the Capital Asset Pricing Model (CAPM).
Conclusion
Credit risk refers to the possibility that comes as a borrower's failure to repay a loan. It affects companies through bad debts. For investors, credit risk comes with bonds. On the other hand, market risk stems from fluctuations in prices or rates in the market. Another name used for market risk is systematic risk. Market risk affects the market as a whole rather than a specific investment.
Originally Published Here: Credit Risk vs Market Risk
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