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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A bank sells EUR 50 million to a counterparty in exchange for USD, with EUR delivered in Frankfurt in the morning and USD delivered in New York many hours later, each leg on its own gross settlement system. The bank's main concern is that it pays the EUR and the counterparty fails before paying the USD. Which description best fits this risk?

This is Herstatt, or principal, settlement risk. Because the two currency legs settle at different times in different systems, the bank may pay out the full EUR amount and then not receive the USD if the counterparty fails, risking loss of principal rather than just replacement cost.

  1. AHerstatt (principal) settlement risk arising from non-simultaneous payment legsCorrect
  2. BReplacement cost risk arising only before the settlement date
  3. CWrong-way risk from correlation between exposure and default probability
  4. DLiquidity risk from delayed receipt of funds that is limited to the interest cost of the delay

Explanation

The bank delivers full principal in one currency before receiving the other because the two legs settle at different times. This is Herstatt or principal settlement risk. Replacement cost applies before settlement, and option D understates the loss, which can be the entire principal.

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