Also known as replacement-cost risk, replacement risk is the degree of possibility that a one party in a contractual agreement will fail to comply with the terms and conditions found in that contract. In situations where one or both parties do not fulfill their contractual obligations, there is a need to seek out and implement what is known as a replacement contract. While there is always a small amount of replacement risk inherent in any business deal, the goal is to only enter into contracts where the risk level is considered within reason.
Lenders often look closely at the degree of replacement risk involved with approving a line of credit, loan, or mortgage. Factors such as the income level of the debtor, past credit history, and the current ratio of debt to assets all help the lender to identify if the borrower is likely to honor the provisions of the contract that governs the relationship. Those same factors can aid the lender in determining that there is a reasonable chance that the borrower will not be able to comply with those provisions at some point in the future. Depending on the amount of default risk that the lender determines is present, the application of the borrower may be rejected, or approved at a higher rate of interest.
Investors also look closely at replacement risk when evaluating various types of investment transactions. For example, before selling a security that is performing well, the investor will want to determine if it is possible to purchase a security that will perform at least as well as the one currently owned. The idea is to minimize replacement risk by assuring that any investments purchased with the funds acquired by the sale will effectively take the place of the sold asset. If the new asset will allow the value of the portfolio to continue increasing at a rate that is equal to or exceeds the previous rate of growth, then the replacement risk is considered low and the investor is highly likely to move forward with his or her strategy.
Depending on the type of business transaction under consideration, the degree of replacement risk may be minimized by including certain provisions within the contract. For example, a lender may require collateral that can be seized in the event that a borrower defaults on a loan. While the collateral may have undergone some amount of depreciation since the contract was instituted, the asset can still be sold and defray at least part of the loss incurred by the lender. That leaves the lender free to pursue a contract with a different borrower, hopefully one that does repay the loan according to terms.