What is Pre-Settlement Risk

The pre-settlement risk is the possibility that one party in a contract will fail to meet its obligations under that contract, resulting in default before the settlement date. This default would prematurely end the contract.

A risk of this type can lead to replacement cost risk as the injured party must enter into a new contract to replace the old one. Terms and market conditions may be less favorable for the new contract.

BREAKING DOWN Pre-Settlement Risk

There is risk associated with all contracts. Risks include one of the parties involved not fulfilling their obligation to perform some action, deliver a stated good or service, or pay their financial commitment. Financial contracts, such as forward contracts or swaps, are no exceptions. Expected risk-adjusted returns must include factoring in counterparty risk.

All parties need to consider worst-case loss that may occur if a counterparty defaults before the transaction settles, or becomes effective. The worst case loss can be adverse price or interest rate movement, in which case the injured party must attempt to enter a new contract with the price or rates at less favorable levels. Other ramifications may involve any potential legal issues for breach of contract.

It is essential to consider the creditworthiness of the other party and the volatility, or likelihood that the market may move adversely in the cost of a default.

For example, let's say ABC company forms a contract on the foreign-exchange market with XYZ company to swap U.S. dollars for Japanese yen in two years. If before settlement, XYZ company goes bankrupt, it will be unable to complete the exchange and must default on the contract. Assuming ABC company still wants or needs to enter into such a contract, it will have to form a new contract with another party, which leads to replacement cost risk.

Replacement Cost Risk

As mentioned, replacement cost risk is the possibility that a replacement to a defaulted contract may have less favorable terms. A good example comes from the bond market and problems created by an early redemption. Some bonds have a call or early redemption feature. These features give the issuer the right, but not the obligation, to buy back all or some of its bonds before they reach maturity. If the bonds carried a 6% coupon and interest rates fall to 5% before the bond matures, the investor would find it difficult to replace the expected income stream with comparable securities.

For an interest rate or currency swap, a change in interest or exchange rates before settlement will result in the same problem, albeit on a shorter timescale.