ACCA Advanced Financial Management (AFM) Practice Exam

Default risk refers to the likelihood that a borrower will fail to meet their debt obligations, which can involve not making timely interest payments or failing to repay the principal amount borrowed. This concept is crucial for lenders and investors as it directly affects the assessment of the creditworthiness of borrowers, whether they are individuals or corporations.

When evaluating potential investments, understanding default risk helps in determining the appropriate level of interest rate to charge on loans or bonds, which should compensate for the risk taken. A higher default risk typically leads to higher interest rates, while borrowers perceived as having lower default risk generally receive more favorable borrowing terms.

Market fluctuations, delayed payments, and interest rate changes, while related to financial risk, do not specifically address the unique aspect of default risk, which centers solely on the borrower's ability to meet their contractual obligations.