Creditworthiness assessment as a way of minimising credit risk Dissertation

Creditworthiness assessment as a way of minimising credit risk - Dissertation Example Introduction Financial firms or investors experience various kinds of risks, out of which the most important is the credit risk. Although the market participants commonly consider the â€Å"credit risk† as one dimensional however there actually are three dimensions f credit risk, namely: credit-default, credit-spread, and down-grade credit risks. Credit default risk is the one in which the issuer will be unable to fulfill the terms of the obligation according to the regular payments of interest as well as the actual loan (Fabozzi, Moorad and Steven, 2003). This type of credit risk includes counterparty risk in a derivative transaction or trade in which the counterparty is unable to meet its obligation. In order to measure the credit default risk, investors generally depend upon credit rating that is a formal perspective of a company functioning as a rating agency for the credit default risk experienced due to investing in a certain issue of debt securities. The nationally appr oved or known rating agencies are Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. Credit spread risk is defined as underperformance or loss of some issue(s) as result of a rise in the credit spread that refers to the compensation desired by the investors so as to recognize an issue’s or issuer’s credit default risk. ... Downgrade risk refers to the risk in which an issuer or issue gets degraded that cause an increase in the credit spread desired by the market. Thus, downgrade risk is associated with the credit spread risk. Some times the potential of an issuer to earn interest and principal payments undermines greatly and surprisingly due to an unpredicted event. This could be any types of peculiar events that are related to an industry or the corporation, such as a natural or industrial accident, a takeover or a corporate restructuring, a regulatory change, or a corporate fraud. This category of risk is generally referred as an event risk and will compel the rating agencies to downgrade the issuer (Fabozzi, Moorad and Steven, 2003). 1.1. Factors Involved in the Assessment of Credit Default Risk The most evident and significant measure to avoid credit risk is to examine the creditworthiness of the borrower. In carrying out such an assessment, credit analysts investigate or measure the factors that i nfluence the business risk of a borrower. These factors are generalized in to four basic categories, which are: the quality of the borrower, the potential of the borrower to fulfill the debt obligation, the seniority level and the security provided in a bankruptcy proceeding, and the constrains applied on the borrower. The quality of the borrower, in the case of a corporation, includes the assessment of the business strategies and management policies of the firm. Being more specific, a credit analyst will examine the strategic plan, the financial philosophy, and the accounting control systems of the corporation in relation to the use of debt (Fabozzi, 2009). The potential of the borrower to fulfill its obligations starts with the assessment of the financial