The Finance Professor: Understanding Risk

Credit risk: Not all companies have an equal ability to repay their debt. Credit worthiness is quantified by credit rating agencies such as Moody's (MCO Quote), Standard and Poor's (MHP Quote), Fitch and TheStreet.com Ratings. Each agency will carefully review a debtor's balance sheet , cash flow , income statement , contracts and debt covenants to ascertain that company's ability to repay its debt.

Typically, the highest credit rating of AAA is given to the most creditworthy companies. This is followed by AA then A then BBB and so on. There are some variations between credit agencies such as use of smaller case letters or minus signs. There is a further delineation between investment grade and noninvestment grade. Investment grade is typically BBB-minus or better, and non-investment grade is typically BB-plus or worse.

Credit risk is subjectively quantified in those ratings, but an individual company's rating may be subject to a credit upgrade or downgrade. We call this situation being under "credit watch." As an investor, you must incorporate this scenario into your credit risk management. Some investors are prohibited from holding non-investment-grade debt, and slipping from investment grade to non-investment grade will have the potential to result in portfolio liquidation and thus add to one's personal credit risk profile.

Counterparty risk: When engaging in a transaction with another party, not only do you have to concern yourself with the ability of that counterparty to pay, you also have to worry about that party's willingness, desire or ability to abide by the covenants of the transaction. While credit risk and counterparty risk may seem similar, they pose different risks to investors.

Credit risk focuses on debt repayment, while counterparty risk focuses on performance of contractual obligations. For example, let's say that you invest in building a new addition to your house and it has a leak in the roof, but the contractor refuses to fix it. In a situation like this, you're exposed to counterparty risk with the contractor for a failure to perform. You can sue that contractor and obtain a judgment. Once you have a judgment, you then add credit risk to the equation, because now you've become an unsecured creditor of the contractor.