The risk that a counterparty fails to deliver its obligation upon settlement while having received the leg owed to it is called:

The risk that a counterparty fails to deliver its obligation upon settlement while having received the leg owed to it is called:
A . Pre-settlement risk
B . Credit risk
C . Replacement risk
D . Settlement risk

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Answer: D

Explanation:

Choice ‘d’ is the correct answer. Settlement risk, as the name suggests, arises upon settlement when one of the parties delivers its obligation under the transaction and the other does not. Consider a EUR/USD FX forward contract maturing in a month. At maturity, one of the parties will deliver EURs and the other USDs. If one party fails to deliver, then it constitutes a very large risk to the other party. This risk is much larger than pre-settlement risk, because the amount at risk is the entire notional and not just the replacement value. Of course, settlement risk exists for a very short period of time, no more than a number or hours or a day.

There is no such thing as ‘replacement risk’, and credit risk is a larger category of which settlement risks is one component. Settlement risk is the most appropriate answer.