CFA Level I · CFA Level I Exam

Credit Risk for CFA Level I: Chapter Guide

Credit risk is the chance that a borrower fails to pay what it owes on time. You measure it as expected loss: probability of default times loss severity. Then you study seniority, ratings, the four Cs, spreads and models. Solve questions by finding the default chance, the recovery, and what the spread pays you for.

What this chapter covers

This chapter is about one question: will the borrower pay you back, and how much do you lose if it does not? It starts with the two building blocks, default probability and loss severity. It then moves to where your claim sits in the capital structure, how rating agencies grade issuers, and how analysts judge a borrower themselves.

The later modules turn credit risk into numbers. Credit spreads show the extra yield investors demand for taking default risk. Structural and reduced-form models give two different ways to think about default and to price it. The chapter ends with two special cases: securitized debt, where credit depends on a pool of assets and its structure, and municipal bonds, where credit depends on the issuer's source of repayment.

The chapter connects to much of the paper. It builds on bond pricing and yield concepts in Fixed Income. It uses ratios from Financial Statement Analysis and leverage ideas from Corporate Finance. Option logic from Derivatives helps with the structural model. It also links to Portfolio Construction, because credit exposure is a key risk in a bond portfolio.

Fixed Income is 11-14% of the 2027 exam, and credit risk is part of that topic. All 180 questions are equally weighted and there is no penalty for wrong answers, so every definition you master is a mark you can win quickly. Credit ideas also reappear in other topics, such as leverage in corporate finance, so effort here pays off more than once. The chapter has many distinctions that trap careless readers, so learn each term precisely.

Credit Risk: topics in the order to study them

1Credit Risk Basics: Default Risk and Loss SeverityIt defines default probability, loss given default and expected loss, which every later topic uses.
2Capital Structure, Seniority and Recovery RatesRecovery depends on where a claim ranks, so it comes right after loss severity.
3Credit Ratings and Their LimitationsRatings summarize default risk and seniority, so you need those ideas first.
4Traditional Credit Analysis: The Four CsIt shows how you form your own view instead of relying on a rating.
5Credit Spreads and Spread MeasuresSpreads put a price on the credit risk you have already learned to judge.
6Structural and Reduced-Form Credit ModelsThese models explain and price default, so they sit best after spreads and risk basics.
7Securitized Debt and Municipal Credit ConsiderationsThese are specialised applications, easiest once the core credit tools are clear.

How to prepare Credit Risk

Treat this chapter as a set of linked ideas, not a list of facts. Build the core vocabulary first, then practise applying it in short questions.

Learn the core terms in the first topic until you can define each in one sentence: probability of default, loss given default, exposure, recovery rate and expected loss.
Practise the expected loss relationship with small numbers until it is automatic, and note that recovery rate and loss severity are complements: loss severity = 1 − recovery rate when both are stated as a share of exposure.
Draw the capital structure as a ladder from senior secured down to equity. Place each claim and say who is paid first in a default.
Make a one-page comparison of rating agency strengths and limitations, and a checklist of the four Cs with an example of what each looks at.
Work spread questions by asking what the extra yield compensates for, then practise the two models by stating each model's core assumption in plain words.
Finish with securitized and municipal credit, then do mixed practice questions. For each three-option question, eliminate the two options that break a definition, and review every miss by naming the concept you confused.

Common mistakes in Credit Risk

Mixing up recovery rate and loss severity.
Fix: Write the link first: loss severity = 1 − recovery rate. Check whether the question gives you the share recovered or the share lost before you calculate.
Treating a credit rating as a guarantee or as a precise measure of default.
Fix: Remember that ratings summarize risk but can be slow to change. When an option claims a rating removes the need for analysis, eliminate it.
Assuming all bonds of the same issuer carry the same credit risk.
Fix: Always ask which claim is being valued. Senior secured debt usually has higher recovery than subordinated debt from the same issuer.
Reading a wider spread as meaning only higher default risk.
Fix: Remember that spreads also compensate for liquidity and other risks. Pick the answer that reflects the full compensation.
Confusing the structural and reduced-form models.
Fix: Tie each to one phrase: structural uses the firm's assets and liabilities with option logic; reduced-form uses observable inputs and a random default event.
Applying corporate credit logic to securitized and municipal debt.
Fix: Ask what repays the debt. For securitized debt, look at the asset pool and structure. For municipal bonds, look at the issuer's revenue or taxing source.

Last-day revision: Credit Risk

Credit risk is the risk of loss from a borrower failing to pay in full and on time.
Expected loss = probability of default × loss given default, applied to exposure.
Loss severity = 1 − recovery rate, when both are stated as a share of exposure.
Senior claims are paid before junior claims, so seniority raises expected recovery.
For the same issuer, senior debt usually has higher recovery and a lower spread than junior debt.
Ratings are opinions, can lag events, and can change sharply, so they are not a full substitute for analysis.
The four Cs are capacity, collateral, covenants and character.
Capacity is the borrower's ability to repay from cash flow, so leverage and coverage matter.
A credit spread is the extra yield over a benchmark that pays for default and other risks, such as liquidity.
Wider spreads mean the market demands more compensation for credit risk.
The structural model views equity as a call option on the firm's assets, and debt as a risk-free bond minus a put option on those assets. Default occurs when asset value falls below the debt's face value at maturity. The reduced-form model treats default as a random event with an intensity.
Securitized debt depends on the asset pool and its structure; municipal credit depends on the source of repayment.

Credit Risk practice questions

Credit Risk in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk: frequently asked questions

How should I study credit risk for CFA Level I?

Start with expected loss and recovery, then seniority, ratings and the four Cs. Move to spreads and models last, then securitized and municipal credit. Finish with mixed practice questions so you learn to tell similar concepts apart.

Is credit risk a calculation-heavy chapter?

No. Most questions test definitions and relationships, with a few simple calculations such as expected loss. You do not need heavy calculator work, but you must read the numbers carefully and know what each term means.

What is the difference between the structural and reduced-form models?

The structural model links default to the value of the firm's assets compared with its debt, using option ideas. The reduced-form model treats default as a random event that depends on observable factors. Exam questions usually ask you to match the idea to the model.

How do I avoid traps in the three-option questions?

Read the stem for what is asked, then drop any option that contradicts a basic definition, such as saying lower seniority raises recovery. With two options gone, the answer is usually clear. There is no penalty for wrong answers, so always answer.