Is this the first time you hear these terms? If so, worry no more, this article has curated everything you need to know.

Definitions

Financial services – they are economic services that the finance industry provides. The financial sector includes a broad range of companies that manage money, including banks, insurance companies, credit unions, consumer finance companies, credit card companies, investment funds, stock brokerages, accountancy companies, and some government-sponsored businesses. You can find financial services enterprises in all economically developed areas and tend to increase in national, local, international, and regional financial centers like New York, London, and Tokyo.

Settlement risk – it is the probability or risk that one party will not fulfill their part of the bargain in a deal or transaction. Settlement risk is mostly associated with forex trading. However, it can also apply to contracts or agreements between two parties. In other words, settlement risk is the risk individuals take in any deal or transaction that the other part will not honor their part of the deal (maybe goods or services or monetary transaction).

Example: Jack hires a contractor to remodel his house for $1000. For the entrepreneur, the settlement risk is Jack might fail to pay the $1000 once he completes the task. Should Jack pay for the job before the work, then he takes the settlement risk: that the contractor will not remodel the house.

Why does settlement risk matter?

It is inherent in every deal or transaction between two parties. If one party does not honor its part of the bargain, it means that the other party will incur a loss. Any party can bear the settlement risk. Some financial service companies can help individuals calculate the settlement risk and advise accordingly on whether to go into the deal or not. It is wise for large enterprises that can afford such services to seek their help to avoid incurring losses if the other party to a contract fails to honor its part of the bargain.

Settlement risk in foreign exchange

As mentioned before, compensation risks quickly affect the foreign exchange market. Forex traders are more likely to be affected by compensation risks compared to risks like translation and transaction risks. However, there are tools financial services can use to manage such risks. One of these tools is spot trade, foreign exchange option deals, and outright forward sales.

How does settlement risk in foreign exchange arise?

The process is the same for most foreign currency transactions. The two parties in a deal agree to trade – amount of one currency in exchange for another currency. In this operation, payments for two currencies are made. However, the two payments are independent.

Traders make payments of one currency with the assumption that the other party will make payment with the agreed amount of the other currency and this is how settlement risk arises. The settlement risk in a foreign exchange transaction occurs when one party does not receive payment in the currency he or she had agreed.

In conclusion, seeking the help of financial services solutions can contribute to reducing the settlement risks.