What are the differences between credit risk and market risk?

Incorporating behavioural analysis can offer a deeper insight. This involves assessing the borrower's past financial behaviour, including spending habits and response to economic shifts, to predict their future creditworthiness. This method recognises that credit risk is a dynamic measure, influenced by personal or organisational behaviour patterns. This perspective can help lenders and investors identify potential risks that might not be immediately apparent from financial statements or credit scores alone.

A preliminary interview with the customer about their past financial backgrounds, their strategies on the worst case scenario and seeking data, evidence in order to cross check the answer of client is basic requirements in order to assess the risk of default and character of the person. An open ended question to the client will somehow gives the idea of attitude and personal beliefs. This will help to assess the risk of default for lenders and investors.

Credit risk refers to the likelihood of a borrower failing to repay a loan or meet their financial obligations. This is linked to an individual entity.

An emerging consideration in managing market risk is the impact of social media and news sentiment on market dynamics. In today's digital era, information spreads rapidly, and investor sentiment can be heavily influenced by social media trends and news cycles. This factor has introduced a new layer of complexity in predicting and managing market risk, as market perceptions can rapidly change, impacting the valuation of assets. Recognising and analysing these trends can be vital for investors and fund managers in making informed decisions and mitigating market risk.

Market risk relates to the potential for losses due to fluctuations in market factors such as interest rates, currency exchange rates, or overall market conditions.

A nuanced difference between credit and market risk lies in their correlation to economic cycles. Credit risk tends to be higher during economic downturns when borrowers are more likely to default due to financial distress. In contrast, market risk is pervasive across economic cycles but may be more pronounced during periods of high market volatility, regardless of the overall economic condition. Understanding this distinction helps investors and risk managers tailor their strategies to the type of risk and the prevailing economic climate.

Credit risk is more at the corporate level and it can affect you if you hold bonds of a company that is leading toward bankruptcy and is unable to repay debt obligations. The way to mitigate this is to invest in a company with a healthy debt profile and keep reviewing the credit ratings of the company. Market risk, on the other hand, is the price volatility that we see in the stock market on a daily basis. The reasons for fluctuation in the price can be external or internal. One way to mitigate is to hold asset classes that are not co-related so the portfolio gets hedged. Secondly, hold the equities for the long-term to ride out short-term volatility and review portfolio frequently.

One of the main differences between credit risk and market risk is that credit risk is specific to a borrower or counterparty, while market risk is common to all participants in a market. Another difference is that credit risk is asymmetric, meaning that there is a limited upside but a large downside potential, while market risk is symmetric, meaning that there is an equal chance of gaining or losing value. A third difference is that credit risk is more dependent on the characteristics and behavior of the borrower or counterparty, while market risk is more dependent on the external factors and events that affect the market.

In practice, credit risk and market risk are often interrelated. For instance, a decline in market prices can increase the likelihood of borrower defaults, leading to a rise in credit risk. Similarly, a deterioration in credit risk can trigger a sell-off in financial markets, exacerbating market risk. Therefore, financial institutions and investors need to carefully manage both types of risk to protect their financial stability. In summary, both are two fundamental types of financial risk that have significant implications for individuals, businesses, and institutions. Understanding the nature of these risks and implementing effective mitigation strategies is crucial for managing financial stability and achieving long-term financial goals.

Credit Risk and Market Risk is interrelated. An economic downturn can both trigger issues in cash flows resulting into default by borrower and lessen the value of asset in consideration. However, one under looked aspect in credit risk assessment is the importance of borrower's behavioural aspects and information on his/credit related conduct. This is known at local level by the lenders operating at the specific market.