Of the various risks that plague any organization, credit risk is the most prominent. This is primarily due to the inherent complexity in understanding as well as measuring credit risk. This article throws light on the theoretical framework of the same and the emergence of the credit derivatives market. The traditional methods of credit risk management and the impact of such products on the Indian economy are also discussed in detail.

Credit risk can be defined as the risk of default by the borrower of a loan. To manage this risk, various financial instruments commonly known as credit derivatives have been developed in the past decades. Banks, financial institutions and other issuers of securities manage the credit risk of their loan portfolio by using these derivatives to insure against the unfavorable changes in credit quality of the borrower.

Credit risk arises when the borrower cannot stick to his commitment of making interest payments on a loan or repayment of principal. When default occurs, banks or other lenders suffer the loss since the promised payment in the form of cash inflows will not be available to them. Credit risk can arise from both business cycles and firm-specific events. Risk of default usually occurs at the time of economic expansion since higher earnings in the economy reduce probability of default by the borrowers. Recession in the economy increases the risk of default as earnings of the corporate houses fall making it difficult for them to make interest or principal repayments. Credit risk, arising from the firm-specific factors is not related to business cycles. Firm-specific credit risk arises from events specific to a firm's business activities or the factors related to the industry.

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