In the world of contract law, pre-settlement risk is the probability that one party will fail to meet its contractual obligations, resulting in default before the actual settlement date. Usually, this happens when one party fails to meet its hedging obligations before the actual settlement date. This can cause a significant loss to the other party. This risk is inherent in all contracts but is particularly prevalent in financial contracts. Although it is not explicitly measurable, it is usually included in the price of the contract.
The concept of pre-settlement risk is more complex. It involves an obligation that is less than the value of the instrument, such as a bond or equity. In some cases, it can also apply to bonds or equity markets. This type of risk results in a risk known as replacement cost, where the injured party must enter into a new contract with a counterparty that may not provide the same terms.
As the name suggests, settlement risk is the risk that a counterparty may default before the final settlement is made. In other words, it is the risk that the other party will not meet their contractual obligations. This risk can be quite substantial, requiring that a party consider the creditworthiness of the counterparty and the likelihood that the market will move against it. If XYZ goes bankrupt before the settlement, ABC will have to forgo the contract and enter into a new one with another party. This is called replacement cost risk