How does market risk differ from credit risk?

Market risk refers to the potential for losses due to changes in market prices, which can include fluctuations in stock prices, interest rates, foreign exchange rates, and commodity prices. It encompasses the risks that investors face as a result of changes in the overall market environment, making it a broad category encompassing various asset classes and economic factors.

In contrast, credit risk specifically arises from the possibility that a borrower will fail to meet their payment obligations as stipulated in a debt agreement. This type of risk is particularly relevant to lenders and investors in debt instruments, as it directly impacts the likelihood of default and the financial recovery in case of non-payment.

Recognizing these distinctions helps in understanding how firms manage different types of risks in their portfolios. Each type of risk requires different strategies and tools for assessment and mitigation. The conflation of market fluctuations with issues of creditworthiness can lead to misunderstandings about risk management and exposure.

Overall, the clarity between market risk related to broader price changes and credit risk centered on repayment capabilities illustrates the fundamental differences critical to risk analysis and management in the financial industry.