University of Central Florida (UCF) FIN4243 Debt and Money Markets Practice Exam 3

Credit risk is best defined as the risk that a loss will occur due to counterparty defaults. This definition captures the essence of credit risk, which involves the possibility that a borrower or counterparty will fail to meet their contractual obligations, leading to financial loss for the lender or investor.

In various financial contexts, such as lending or trading, assessing credit risk is crucial because it helps institutions evaluate the likelihood of default and make informed decisions regarding risk management and investment strategies. Entities exposed to credit risk must conduct thorough due diligence to assess the creditworthiness of borrowers or counterparties, ensuring that they can fulfill their obligations.

The other options represent different types of risks that are not specifically related to the potential failure of a party to honor their financial commitments. For instance, operational failures pertain to management issues rather than credit conditions, price distortions relate to market inefficiencies rather than defaults, and prepaid assets involve considerations of cash flow timing rather than the counterparty's reliability.