What does risk-based pricing involve?

Risk-based pricing involves setting the price of a financial product based on the specific risk associated with the borrower or the investment. This pricing strategy takes into account the individual characteristics of the borrower, such as their credit history, income level, and the overall risk profile. By aligning the price with the assessed risk, lenders and investors can ensure that they are adequately compensated for the potential risks they are taking on.

This approach helps financial institutions manage risk more effectively, as it allows them to adjust pricing to reflect the likelihood of default or losses. For instance, borrowers who present a higher risk may face higher interest rates or less favorable terms, while lower-risk borrowers may benefit from lower rates. This differentiation in pricing encourages responsible borrowing and lending practices.

In contrast, setting prices based on an average market rate overlooks individual risk attributes, while determining price solely from historical performance does not account for current risk factors. Similarly, assessing market demand before pricing a product focuses more on supply and demand dynamics rather than the inherent risks of the financial products themselves.