Default risk - Financial definition
Financial acronyms
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Concise definition of the term default risk
Risk of a financial loss caused by the incapacity of the debtor to meet his financial obligations (interest payments, reimbursement …) resulting from a financial contract or transaction.
Comprehensive definition of the term default risk
Default risk not only arises from loans, be it bank loans or debt securities, but more generally
from any type of financial contract from which a claim originates at any given time.
Depending on the nature of the contract or transaction, the debtee has various means of pretecting himself
against default risk.
In case of a loan for example, he can demand for the transaction to be accompanied by a guarantee, provided
either by the debtor himself, or by a specialized institution.
Interbank loans for example are generally guaranteed by collateralized securities, the guarantee being adjusted with margin calls should the value of the latter decrease so that the loan is no longer adequately protected.
Interbank loans for example are generally guaranteed by collateralized securities, the guarantee being adjusted with margin calls should the value of the latter decrease so that the loan is no longer adequately protected.
In the case of a debt security, the security holder can cover his risk by entering into a credit
default swap (CDS) which will, depending on the applicable credit events defined in the contract, compensate
him for a downgrade or a default.
In any case, the debtee will generally demand a higher level of interest (or other form of compensation)
for taking additional risk. This excess interest is called risk premium.