Certified Financial Management Specialist Practice Exam

What does credit risk refer to in finance?

1. The risk of losing money on investments

2. The risk of a borrower defaulting on a loan

3. The risk associated with currency exchange

4. The risk of costs exceeding budgets

The correct answer is: The risk of a borrower defaulting on a loan

Credit risk refers specifically to the possibility that a borrower will fail to meet their obligations in accordance with agreed terms, primarily resulting in default on a loan. When lenders extend credit, there is always a chance that the borrower may not repay the principal or interest, leading to financial losses for the lender. This risk is critical in the lending process as it directly impacts financial institutions' profitability and stability. Management of credit risk involves assessing the borrower's creditworthiness, setting appropriate lending terms, and maintaining a diversified portfolio to mitigate potential losses. Various tools, such as credit scores and risk assessment models, are used to gauge this risk before extending credit. The other options address different types of risks that are not related to the borrower's ability to repay. Investment risk pertains to the volatility and potential loss associated with investing in financial assets. Currency risk involves fluctuations in exchange rates affecting the value of international investments or transactions. Budgetary risk refers to the potential for project costs to exceed the anticipated amounts, leading to financial overruns. Each of these risks exists within its specific context, distinct from credit risk.