Difference between credit risk and interest rate risk

On the credit market, players are exposed to several types of risk that may affect either the guarantees of the financial transactions they carry out, or the repayment of their debts, or the counterparties generated by their commercial operations, etc. Among these risks, interest rate risk and credit risk deserve special attention in that they largely determine the sustainability of companies, as well as the profitability of several transactions. What is it about ?

Interest rate risk refers to possible financial losses related to currency fluctuations, particularly in terms of reinvestment or disinvestment in the markets. It results in the possibility of capital losses, whether permanent or temporary. More simply, it is the change in the price of an asset, caused by a change in interest rates.

In practice, the interest rate risk is present during a mortgage loan or a variable rate bond placement. Financial institutions such as banks are regularly exposed to this type of risk for both their balance sheet and off-balance sheet transactions. For the holder of a fixed-rate bond, a change in the price of the bond can result in either a capital gain or loss.

Indeed, when the interest rates on the bond market increase beyond the initial yield of the bond, the value of the latter decreases. On the other hand, when interest rates fall, the real value of the bond increases. In a company, the interest rate risk can manifest itself at the level of the income statement as well as at the level of the balance sheet. At the level of the balance sheet, it is the value of the assets or that of the liabilities which may undergo variations.

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At the level of the income statement, it is manifested by the fall in financial income in the event of a fall in interest rates, or an increase in financial charges in the event of an increase in interest rates. For a company, this risk refers to the possibility that a drop in interest rates will affect the return on investments or increase expenses. However, interest rate risk and credit risk should not be confused!

It corresponds, for example, to the contingencies that may arise when a creditor is not reimbursed by his debtor in the context of a loan. At the bank level, each lending transaction further exposes the institution to varying risks. This implies that they must meticulously analyze the interest rate risks of each case, taking care to finance long-term loans only with long-term funds, and short-term loans only with short-term funds.

For individuals or SMEs, and unlike interest rate risk, credit risk can simply be assessed on the basis of credit files and the guarantees offered. But for large companies, the risk analysis must go beyond simple guarantees by taking into account several data deemed significant such as the balance sheet, the income statements, the deadline requested, etc.

Credit risk has three components:

However, credit and interest rate risks are of a similar nature. Indeed, in one or other of the cases, they take part in the determination of the cost of the financing to be granted to the borrowers or, in the determination of the remuneration or the interest of the lenders. A good analysis of the interest rate risk can also make it possible to determine the appropriateness of a loan for the company and to help the financial institution to decide on a refusal of credit or a financing agreement.

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