What characterizes credit risk compared to market losses?

Credit risk is fundamentally characterized by the potential for loss due to a borrower or counterparty failing to meet their financial obligations. In this context, the nature of credit risk is inherently one-sided and considered all downside because it primarily represents the risk of a total loss if the credit event, such as default, occurs.

When we speak of credit risk, it is important to understand that the lender or investor faces a scenario in which they could lose the entirety of their investment if the borrower defaults. Unlike market risks, which can also present opportunities for gains as well as risks for losses, credit risk does not offer a corresponding upside when the credit quality of the borrower deteriorates.

The potential for recovery (should the borrower be able to improve their financial situation) does not negate the fundamental characteristic of credit risk since, at the moment of default, the lender's position turns to the full realization of loss. Thus, in situations classified under credit risk, the risk is that there will be no value recovered, which reflects the one-sided and all downside nature of this form of risk.

Understanding this distinction is crucial for managing risk in a portfolio, as credit risk does not balance out with potential gains like market risk does.