Analytical Finance: Volume I – The Mathematics of Equity Derivatives, Markets, Risk and Valuation : [PDF Download]

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“Settlement risk is related to credit risk and is defined as the risk that an expected settlement payment on an obligation will not be made on time due to bankruptcy, inability or time zone differential.

A common example involves bilateral obligations in which one party makes a required settlement payment and the counterparty does not. Settlement risk provides an important motivation to develop netting arrangements and other safeguards.

When related to currency transactions, the term Herstatt risk is sometimes used. This is the risk that one party to a currency swap will default after the other side has met its obligation, usually due to a difference in time zones.

The settlement of different currencies in different markets and time zones from the moment the sold currency becomes irrevocable until the purchased currency receipt is confirmed.

The two parties are paid separately in local payment systems and may be in different time zones, resulting in a lag time of three days and mounting exposure that may exceed a party’s capital. The risk is reduced by improved reconciliation and netting agreements.”

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