The Meaning of “Delivery Risk”
When a party to a contract faces delivery risk, it means that there is a chance that it will not deliver the asset or cash value promised under the terms of the contract.
Settlement risk, default risk, and counterparty risk are some alternative ways of describing this scenario.
It’s something both parties should think about before signing any sort of financial agreement. All monetary transactions involve some degree of delivery risk.
KEY PHRASES
- As in settlement or counterparty risk, delivery risk is the possibility that a contracting party will fail to fulfil its obligations.
- A premium may be attached to the agreement if one counterparty is deemed riskier than the other.
- Even though it happens infrequently, delivery risk increases when economic uncertainty is high.
- Most asset managers protect themselves from the potential loss of dealing with a counterparty by using collateral such as cash or bonds.
- Delivery risk can also be reduced through the use of credit reports, mark to market, and settlement through clearing houses.
How Delivery Risk Works
While normally low, delivery risk rises during times of global financial strain, such as those that followed the September 2008 collapse of Lehman Brothers.
It was one of the largest financial collapses ever, and it got people talking about delivery risk again.
Today, collateral is widely used by asset managers as a means of mitigating the negative effects of counterparty risk.
When a counterparty defaults, an institution’s losses are limited to the difference between the value of the collateral held and the replacement cost of the deal, if any.
If they foresee a high level of risk, most fund managers will require substantial margin above the derivative’s value as collateral.
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Exceptions and Cautions
Over-the-counter (OTC) trading in bond and currency markets is further protected against with mark-to-market (MTM) and clearing house settlement.
Lenders in consumer and business finance frequently consult credit reports before extending credit for large purchases like cars, homes, and businesses.
Unsecured loans in particular carry a much higher interest rate premium when the borrower has a poor credit history.
A premium may be attached to the agreement if one counterparty is deemed riskier than the other.
Delivery risk, or Herstatt risk (after the small German bank that defaulted on its obligations), is a term used in the foreign exchange market.
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Example of Delivery Risk
There are a number of indicators that financial institutions look at to ascertain whether or not a counterparty poses an increased risk of defaulting on payments.
They use the company’s financial statements and a variety of ratios to estimate the probability of repayment.
Whether or not a company will have trouble meeting its financial obligations can be inferred from its free cash flow.
A higher delivery risk may be present with a company that is experiencing negative or declining cash flow.
Risk managers in the credit market estimate credit exposure in a credit derivative by taking into account credit exposure, expected exposure, and future potential exposure.
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