The risk that arises from a party to a transaction failing to meet its obligation on the settlement date, so that its counterparty may have to replace (find an alternative for) the original transaction at current market prices (replacement cost).This risk implies that the possibility that a replacement to a defaulted contract  or transaction may come at a higher cost (i.e., with less favorable terms).

For example, early redemption of a bond may give rise to a situation where the holder, because of the issuer exercising the call option, needs to find a replacement at current market conditions (which may turn out to be unfavorable).

Such a risk translates into the loss of unrealised gains on unsettled transactions with a counterparty. The resulting exposure reflects the “additional” cost of replacing the original contract/ transaction/ security at current market prices.