In this situation, the investor would be exposed to pre-settlement loss of just the difference in market value between the dollar and euro payments.

Since the difference is 0.05, i.e. (1.35 − 1.3),

Pre-settlement loss = EUR 2,000,000 × 0.05 × USD/EUR = $100,000
Following the movement in exchange rates, the contract is now out of the money with regard to the investor because although they can now fetch a better exchange rate on the market, they must honor the terms of the contract and settle the contract at a lower rate.

Things to Remember

• Settlement risk arises from the possibility that one party will fail to deliver on their obligation in a financial transaction.
• Forward foreign exchange contracts are agreements between two parties to exchange a specified amount of currencies at a future date at a predetermined exchange rate.
• Pre-settlement risk is the risk of loss before the actual settlement of a transaction occurs.
• Exchange rate movements can impact the value of forward contracts, leading to potential pre-settlement gains or losses for the parties involved.