What is credit risk?

Credit risk is the risk that a borrower or counterparty will not pay what they owe, in full or on time. For a lender it means lost income and lost principal. It matters because every loan, trade credit and bond carries it, and it determines what interest rate is needed to make lending worthwhile.

How it works

Expected loss is commonly split into three parts: the probability of default, the exposure at the moment of default and the loss given default, meaning the share that cannot be recovered. Expected loss = probability of default × exposure × loss given default. Lenders price this into the interest rate and set aside reserves for it.

The trade-off is between rate and risk. Riskier borrowers pay more but fail more often. Losses also tend to arrive together, because a downturn hurts many borrowers at once, so the actual loss in a bad year can be far larger than the expected average. That clustering is what makes credit portfolios dangerous.

Example

Say a lender makes 1,000 loans of 10,000 each. Each has a 2% chance of default, and if one defaults the lender recovers 40%, so loss given default is 60%. Expected loss per loan is 0.02 × 10,000 × 0.60 = 120, or 120,000 across the book. To break even on this alone, interest must cover about 1.2% of the amount lent. If a recession doubles defaults to 4%, the expected loss doubles to 240,000. These numbers are illustrative.

How to model it in Machinations

Draw a Pool of loans outstanding and a Gate that sends a Lever-set percentage of them to default each step. Defaulted amounts flow to a Converter that recovers a share as cash and a Drain that takes the rest as losses. Interest arrives from a Source into a cash Pool. Play many times at once, and raise the default probability to see how the profit spread widens and how often the cash Pool ends below zero.