Default risk is the possibility that a debtor will not be able to repay their principal and interest as per the agreed time. This inability of a borrower to repay their loan in time is also referred to as credit risk. For instance, a company may fail to pay a bond that has reached maturity. Usually, the default risks go high if the borrower has a lot of liabilities and poor cash flow. As such, default risk has a significant impact on the value of the bond. It also helps potential lenders determine if an individual or company deserves to be given a loan. They do an assessment first before deciding on whether to lend money. Default risk can be measured by getting the percentage of bonds expected to default. Those with high default risk are at a higher risk of being denied loans by financial institutions and if they are given, they are charged more interest rates. An investor should also gauge how much they can get in case there is a default and possibly consider hiring a company providing settlement risk solution services in the case that their counterparty does default.
There are four major examples of default risks; strategic default risk, sovereign default risk, orderly default and sovereign strategic default. Strategic default risk is whereby an individual or organization fails to pay their loan yet they are capable of repaying. This mostly happens in situations whereby the creditor cannot make any claims on the borrower and is common with nonrecourse loans. It is purely voluntary and deliberate. For example, a borrower may weigh the benefits of defaulting against paying a mortgage and opt to default. Strategic sovereign default risk is whereby nations or states choose to default repaying their debts regardless of their ability to repay their debts. Whereas a sovereign state takes total control of its affairs and thus is under no obligation to repay its debts, serious consequences may affect the nation such as being secluded by other countries and also they may in future not benefit from other lenders. On the other hand, a sovereign default risk is a refusal or failure by a certain government to repay their creditors in full. They may give reasons behind the default or still remain silent. The last example of default risk is the orderly default. This is a sort of controlled bankruptcy. When a state or organization is going through rough financial times, they may plan an orderly default which is also known as a controlled default. The debtors must, however, plan the default in time to avoid hurting the lenders.
Any financial institution that lends money is at the risk of experiencing default risks. However, it is good to do an analysis of the probability of a default risk occurring and what they can get in return. If there is a high probability of default risk likelihood, they may choose to stay safe and deny any parties that seem untrustworthy or incapable of repaying. Whereas sometimes strategic default may seem to be a good option, it may end up causing adverse effects to the defaulter.