Also referred to as settlement risk, delivery risk means any counterparty in an agreement may not be able to fulfill its obligations through failure to deliver or pay for assets as outlined in the agreement. In the context of foreign exchange, the term is also known as Herstatt risk. With investment markets, delivery risk is usually a rare occurrence, though perception is another matter. Oftentimes when major collapses happen in an industry sector this perception is heightened, but usually various settlement measures are taken to mitigate the actual risk. Applied to business contracts, however, delivery risk is much more common and requires foresight in possible exposure and effective measures to mitigate potential damage.
Another closely associated term common in financial markets and in international business dealings is overnight delivery risk. Due to differences in time zones, a party to a transaction may not know if a required payment or delivery is made until the next business day. This poses a risk since the party involved does not know this information in time to do something about it effectively or immediately, such as alert the other party that the delivery or payment has not been made as agreed. Therefore, management of delivery risk is of crucial importance.
Delivery risk exists in all transactions and commodities or services physically delivered. Inherent to the delivery process, this risk carries through from the initiation of an order or transaction, through physical delivery, and only ends when final payment is received. Organizations, therefore, will develop methods to calculate and mitigate potential delivery risks.
Calculation of such risk is usually done by making assumptions about how much risk can be incurred in any one transaction. Over the life of a trade — for example, the delivery of natural gas — there are usually peaks and valleys with varying exposures to delivery risk. Companies will usually plot out the dates of delivery as specified in a delivery contract and plot out dates for payment. Using this information, the company can determine its exposure at any point during the contract. As a rule of thumb, companies will usually not deliver an asset without payment if the total amount of the asset exceeds what it can comfortably loan in cash with repayment.
If a company finds it cannot afford the risk, the firm may renegotiate the contract or may implement mitigation measures. Commonly, there are two effective mitigation measures to delivery risk: prepayment or issuing a letter of credit through a bank. Prepayment is fairly straightforward in that an organization will not deliver an asset without payment upfront. Letters of credit from a bank are used because banks are often in a better position to evaluate the creditworthiness of a company. Upon issue, if the counterparty does not make payment, the bank will make the payment as agreed by the counterparty and then proceed with collection actions.