What is pre-deal risk?
Pre-settlement risk is the possibility that one of the parties to a contract will fail to perform its obligations under that contract, resulting in a default before the settlement date. This breach by one of the parties would prematurely terminate the contract and leave the other party to suffer losses if it is not insured in some way.
- Pre-settlement risk is associated with all contracts, but the phrase is most often applied to financial contracts such as forward contracts and swaps.
- The actual cost of pre-settlement risk is not specifically calculated, but is generally understood to be included in the price of such contracts.
- Pre-settlement risk applies in very rare cases to equity and bond markets, but is less of a concern there than in other financial instruments.
Understanding risk prior to agreement
Pre-settlement risk can also lead to replacement cost risk, as the injured party must enter into a new contract to replace the old one. Market terms and conditions may be less favorable for the new contract.
There is a risk associated with all contracts. Pre-settlement risk is more of a concept than a fungible cost. This risk includes that one of the parties involved does not comply with its obligation to perform a predetermined action, deliver a declared good or service or pay a financial commitment.
The cost of this risk prior to settlement is not explicit, but is integrated into the prices and fees of the contracts. This risk is much more applicable in derivatives such as forward contracts or swaps. Risk-adjusted expected returns should include counterparty risk factoring, as it will be included in the price of these transactions. Different exchanges do this in different ways. For example, futures transactions partially distribute this risk among clearinghouse fees collected through the exchange.
All parties should consider the worst-case loss that can occur if a counterparty defaults before the transaction is settled or goes into effect. The worst-case loss may be an adverse price or interest rate movement, in which case the injured party should attempt to enter into a new contract with the price or rates at less favorable levels.
If a counterparty defaults before a transaction is settled or goes into effect, the ramifications can involve any potential legal problems for breach of contract.
It is essential to consider the creditworthiness of the other party and the volatility or probability that the market will move adversely in the cost of a default. For example, let’s say Company ABC signs a foreign exchange contract with Company XYZ to exchange US dollars for Japanese yen in two years. If before the liquidation, the XYZ company goes bankrupt, it will not be able to complete the exchange and will have to breach the contract. Assuming that ABC Company still wants or needs to enter into such a contract, it will have to form a new contract with another party, which carries a risk of replacement cost.
Pre-settlement risk exists, in theory, for all securities, but short-lived stock trades may have such a small part of the trading 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 for a breached contract will have less favorable terms. A good example comes from the bond market and the problems created by an early redemption. Some bonds have a call or early redemption function. These characteristics give the issuer the right, but not the obligation, to buy back some or all of its bonds before they reach maturity. If the bonds have a 6% coupon and interest rates drop to 5% before the bond matures, it will be difficult for the investor 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 time scale.