What is Settlement Risk?
Settlement risk refers to the risk or probability that one party will not uphold their contractual obligation in a transaction or deal.
How Does Settlement Risk Work?
Settlement risk is most often associated with currency trading. However, it can also apply to any contractual deal between two parties. Settlement risk is the risk taken by each party in a contractual transaction that the other party will not uphold their end of the bargain (e.g. monetary payment or delivery of goods/services).
To illustrate, suppose Bob, a remodeling contractor, enters into a deal with Jack to remodel his kitchen for $5000. For Bob, the settlement risk is that Jack will fail to pay Bob the $5000 he owes once the kitchen is remodeled. Should Jack agree to pay Bob the $5000 prior to the job, Jack then takes on the settlement risk: that the kitchen remodeling will not occur or will not be completed.
Why Does Settlement Risk Matter?
Settlement risk is inherent in any transaction between two parties. In the event one party does not uphold their obligations in a transaction, it represents a loss on the part of the other party. For this reason, settlement risk is the risk of loss for either party should the counterparty not come through.