Pre-Settlement Risk: What It Is, How It Works

What Is Pre-Settlement Risk?

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 by one party would prematurely end the contract and leave the other party to experience loss if they are not insured in some way.

Understanding Pre-Settlement Risk

Pre-settlement risk can additionally 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.

There is risk associated with all contracts. Pre-settlement risk is more of a concept than a fungible cost. This risk includes one of the parties involved not fulfilling their obligation to perform a predetermined action, deliver a stated good or service, or pay a contracted financial commitment.

The cost of this pre-settlement risk is not explicit, but rather it is built into the pricing and fees of the contracts. This risk is much more applicable in derivatives such as forward contracts or swaps. Expected risk-adjusted returns must include factoring in counterparty risk as this will be included in the pricing of these transactions. Different exchanges do this in different ways. For example, futures transactions partially spread this risk across the clearinghouse fees levied through the exchange.

All parties need to consider the worst-case loss that may occur if a counterparty defaults before the transaction settles or becomes effective. The worst-case loss can be an 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.

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.

Pre-settlement risk exists, in theory, for all securities, but trades in equities that last for a short duration may have such a small portion of the trade costs associated with counterparty risk that it is an indistinguishable part of the transaction.

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.