What can lead to Credit Risk in financial contracts?

Credit risk in financial contracts primarily arises from the possibility that a counterparty will fail to fulfill their financial obligations, which is termed a default. When a counterparty defaults, it means they are unable to make the required payments or meet their contractual commitments, leading to potential losses for the other party involved in the contract.

This risk is particularly crucial in any financial dealings that involve loans or credit, as the lender or investor faces the uncertainty of repayment. The assessment of credit risk typically involves evaluating the financial health of the counterparty, their credit rating, and market conditions.

Fluctuating interest rates, changes in liquidity, and inaccurate asset valuations can contribute to the overall risk environment but do not directly cause credit risk in the same way that counterparty defaults do. Fluctuating interest rates may affect the valuation of financial contracts, changes in liquidity may impact market conditions, and inaccurate asset valuations can lead to poor investment decisions, but it is the counterparty's failure to pay that fundamentally defines credit risk.