[Fegu]

Delivery risk arises from the fact that both sides to an FX trade settle simultaneously, i.e. we pay out monies, without being 100% certain that our counterparty has remitted the equivalent amount to our account. In the event that we initiate a payment and while the payment is in transit, our counterparty declares bankruptcy, we stand to lose the entire principal amount of the FX transaction. Given the usual size of an FX deal, this can be substantial. However, the risk is only of very short duration.

Replacement Risk
Replacement risk is the main credit risk inherent in forward transactions. If, during the life of a forward contract, a counterparty should become insolvent and unable to honor its forward commitments, the other counterparty will be exposed to the extent of the loss from the market movement on the trade.

It is to everyone’s advantage to mitigate this exposure across a portfolio of contracts by having a valid netting agreement in place. Without a netting agreement the administrator in a bankruptcy might be able to cherrypick the winning trades and leave you sitting with the losing trades. Netting agreements are standard today and are incorporated into wider agreements like ISDA, FEOMA, etc.

The bottom line for the market risk is that the credit risk is really a function of volatility and time to expiration of the contract. The credit risk is the joint probability of an adverse market move and the risk of default for the counterparty in question.