Delivery Risk: What it Means, How it Works

What Is Delivery Risk?

Delivery risk refers to the chance that a counterparty may not fulfill its side of the agreement by failing to deliver the underlying asset or cash value of the contract. Other terms to describe this situation are settlement risk, default risk, and counterparty risk. It's a risk both parties must consider before committing to a financial contract. There are varying degrees of delivery risk that exist in all financial transactions.

How Delivery Risk Works

Delivery risk is relatively infrequent but increases during times of global financial strain like during and after the collapse of Lehman Brothers in September 2008. It was one of the largest collapses in financial history and brought mainstream attention back to delivery risk.

Now, most asset managers use collateral to minimize the downside loss associated with counterparty risk. If an institution holds collateral, the damage done when a counterparty goes belly up is limited to the gap between the collateral held and the market price of replacing the deal. Most fund managers demand collateral in cash, sovereign bonds and even insists on significant margin above the derivative value if they perceive a significant risk. 

Special Considerations

Other measures to mitigate this risk include settlement via clearing house and mark to market (MTM) measures when dealing with over the counter trading in bonds and currency markets. 

In retail and commercial financial transactions, credit reports are often used to determine the counterparty credit risk for lenders to make auto loans, home loans and business loans to customers. If the borrower has low credit, the creditor charges a higher interest rate premium due to the risk of default, especially on uncollateralized debt.

If one counterparty is considered riskier than the other, then a premium may be attached to the agreement. In the foreign exchange market, delivery risk is also known as Herstatt risk, named after the small German bank that failed to cover due obligations.

Example of Delivery Risk

Financial Institutions examine many metrics to determine if a counterparty is at an increased risk of defaulting on their payments. They examine a company's financial statements and employ different ratios to determine the likelihood of repayment.

Free cash flow is often used to establish the groundwork for whether the company may have trouble generating cash to fulfill their obligations.

A company with negative or shrinking cash flow could indicate higher delivery risk. In the credit market, risk managers consider credit exposure, expected exposure and future potential exposure to estimate the analogous credit exposure in a credit derivative.