What is credit risk?

Credit risk refers specifically to the risk that a borrower may fail to meet their obligations in accordance with the terms of a loan agreement. This is particularly relevant for lenders and investors who provide capital, as it directly impacts their return on investment. When a borrower defaults, they do not repay the principal or interest on the borrowed amount, leading to financial losses for the lender or investor. Understanding credit risk is crucial for financial institutions as they assess the likelihood of borrowers being unable to fulfill their payment duties.

In this context, other options do not pertain to credit risk. Fluctuations in stock prices relate to market risk, losing a security during trading addresses operational risk, and market downturns involve systemic risk. Therefore, recognizing that credit risk specifically deals with the borrower's ability to repay clarifies why it is essential for those involved in lending and investing.