Default Risk

Default risk, also known as credit risk, is the possibility that a borrower will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To compensate for taking on default risk, lenders typically charge rates of return that correspond to the debtor’s level of default risk. The higher the risk, the higher the required return, and vice versa. Credit ratings are often used to estimate default risk, with lower-rated bonds offering higher yields to compensate for the higher risk.