What is meant by 'credit risk'?

Credit risk refers specifically to the potential that a borrower may fail to meet their obligations in accordance with the agreed-upon terms of a loan. This risk is integral to the lending process, as it assesses the likelihood that the borrower will default, meaning they do not repay the loan as expected. Lenders evaluate credit risk to determine the creditworthiness of potential borrowers, often considering factors such as credit history, income stability, and overall financial health.

Understanding credit risk is crucial for financial institutions, as it directly impacts their financial stability and profitability. Effective management of credit risk involves several strategies, including risk assessment, setting appropriate interest rates reflective of the risk involved, and maintaining diversified loan portfolios to mitigate the potential impact of defaults.

On the other hand, the other choices relate to different types of risks encountered in finance but do not specifically focus on the aspects of borrower default. For instance, fluctuating interest rates are tied to interest rate risk, market volatility links to market risk, and losing investment capital pertains to investment risk. Each type of risk plays a role in the broader context of financial decision-making but do not encapsulate the essence of credit risk.