It originates from the fact that counter parties may willing or unable to fulfill their contractual obligations. Its effect is measured by the cost of replacing cash flows if other party defaults.
Credit risk should be defined as the potential loss in mark to market value that may incur due to occurrence of credit events. A credit event occurs when there is a change in the counter party’s ability to perform its obligation.
Credit risks can be of following two types-
Ø Sovereign Risk
Ø Settlement Risk
Sovereign Risk: It occurs like when countries impose foreign exchange controls that make it impossible for counter parties to honour their obligation. This type of risk is country specific.
Settlement Risk: It occurs when two payments are exchanged the same day. This risk arises when the counter party may default after institution already made its payments. Settlement risk is very real for foreign exchange transaction, which involves exchange of payments in different currencies at different times.
Credit risk is controlled by credit limits or notional, current & potential exposures and increasingly, credit enhancement features such as requiring collateral of marking to market.
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