Which statement about the relationship between discounting and credit risk is true?

• A. Discounting increases credit risk.
• B. Discounting eliminates credit risk completely.
• C. Discounting reduces credit risk.
• D. Discounting has no effect on credit risk.

Answer: (C)

Discounting frames the value of future payments in terms of their present worth, using a rate that can reflect credit risk. When you apply a risk-adjusted discount rate, the present value of expected cash flows is lowered to account for the chance of non-payment. That adjustment directly affects pricing and structuring, making terms more conservative and reducing the lender’s exposure to potential losses from default. In this sense, discounting helps manage and reduce credit risk by embedding the likelihood of default into the valuation. It does not eliminate risk entirely—defaults can still occur—but it actively lowers the measured risk in the financial analysis by requiring compensation for that risk.