Default risk or Credit risk:

Let us explore at this stage the concept of interest rate risk. Even though bonds are called risk-free assets, there are several reasons why bonds might actually involve risk. First of all, debtors may fail to meet the payment obligation embedded in the bond. If the debtor fails to meet such payment we say the debtor has defaulted.

Risks of this type are called default risk or credit risk. Secondly, there may be inflation risk if, even though the debtor has met the payment obligation, the general price level has gone up. There may be other types of risk as well. Suppose the creditor (purchaser of the bond) requires money before the maturity period and tries to sell the bond. However, there is no price guarantee before maturity. The creditor can sell the bond, but the price that will prevail is unpredictable. The risk of having to sell at a given time at low prices is called liquidity risk. In this unit, however, we do not consider these risks, although the next unit will deal with credit risk and other risks in greater detail. For the present, we are concerned with interest rate risk, and we turn to that now.