What does 'incremental risk' refer to?

Incremental risk specifically pertains to the risk of loss that can arise from a deterioration in the credit quality of a particular investment, often within a portfolio. This type of risk is particularly relevant for investments in bonds or other fixed-income securities where changes in the issuer's creditworthiness can lead to a direct impact on the security's value. By focusing on an individual investment's credit risk, one can assess how potential changes in credit ratings or borrower defaults might affect the overall performance and risk profile of an investment.

The correct understanding of incremental risk emphasizes that it is distinct from broader market risks or macroeconomic factors. While changes in market conditions, inflation, and economic downturns can affect a portfolio generally, incremental risk zooms in on specific credit events and their immediate financial impact. This makes it crucial for risk managers who aim to evaluate and mitigate the specific vulnerabilities of their investments in relation to credit quality.