How is credit risk defined?

Credit risk is defined as the risk that a borrower will default on their debt obligations, failing to meet the terms of their loan or bond agreements. This risk is critical for lenders and investors to assess because it directly affects the likelihood of receiving expected cash flows. In the context of bonds, for example, if a company or individual cannot make interest payments or repay principal, the lender or bondholder will experience losses. Understanding credit risk helps investors make informed decisions about which securities to purchase, taking into account the creditworthiness of the borrower or issuer.

The other definitions do not accurately capture the essence of credit risk. Economic recessions (option A) can influence various financial factors but are not solely representative of credit risk. The potential for stock price decreases (option C) relates more to market risk rather than credit risk. Finally, the variation in investment returns (option D) is indicative of volatility and risk in general, but does not specifically pertain to the probability of borrower default. Thus, the focus on borrower defaulting on debt payments clearly defines credit risk.