Settlement risk (non-financial risk): The possibility that one side of a position is paying while the other is defaulting Credit risk (financial risk): Default of a counterparty I don’t understand 1) how the definitions of the two are any different and 2) why settlement risk is non-financial risk while credit risk is financial risk My thought is that settlement risk simply refers to a counterparty that misses a payment or is late on a payment while credit risk means that the counterparty has no intention to pay ever at this or any future settlement. Therefore, credit risk is impacted by financial markets turmoil while settlement risk is more idiosycnratic factors. This is how I would answer my questions 1) and 2). Is this correct? Thanks.
Credit risk is the risk of loss caused by a counterparty or debtor’s failure to make a promised payment. This definition reflects a traditional binary concept of credit risk, by and large embodied by default risk (i.e., the risk of loss associated with the nonperformance of a debtor or counterparty). For the last several years, however, credit markets have taken on more and more of the charac- teristics typically associated with full-scale trading markets. As this pattern has developed, the lines between credit risk and market risk have blurred as markets for credit derivatives have developed.7 (Level III Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives , 4th Edition. Pearson Learning Solutions 220). The process of settling a contract involves one or both parties making payments and/or transferring assets to the other. We define settlement risk as the risk that one party could be in the process of paying the counterparty while the counter- party is declaring bankruptcy. (Level III Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives , 4th Edition. Pearson Learning Solutions 223). With swaps and forward contracts, settlements take the form of two-way payments. Two-way payments create the problem that one party could be in the process of paying its counterparty while that counterparty is declaring bankruptcy and failing to make its payment. (Level III Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives , 4th Edition. Pearson Learning Solutions 224).
he process of settling a contract involves one or both parties making payments and/or transferring assets to the other. We define settlement risk as the risk that one party could be in the process of paying the counterparty while the counter- party is declaring bankruptcy. (Level III Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives , 4th Edition. Pearson Learning Solutions 223). – is also called Herstadt risk.
Cross Default Provision - Most direct lending or derviative based credit contract stipulate that if a borrower defaults on any outstanding credit obligations, the borrower is in default on them all. Creditors stipulate this condition as one means of controlling credit exposure; in particular, it allows them to act quickly to mitigate loses to counterparties unable to meet any of thier obligations (R39, CFAI LIII Vol5, pg. 250)