Principal risk
Also written Principal risk in settlement
The risk of having paid or delivered without receiving the other side — the settlement half of counterparty risk, eliminated by a central counterparty acting through novation.
In plain language
Two things can go wrong when a counterparty fails, and they are not the same size.
The first is that the trade has to be replaced at a worse price. That is replacement cost risk, which the workbook also calls pre-settlement risk.
The second is far worse. You have already paid, or already delivered, and nothing came back.
That is principal risk, and it arises during settlement. The workbook's definition: principal risk arises when the buyer or seller has not received the goods or funds but has fulfilled his own obligation of making payment or delivering goods.
The name tells you the size of it. What is at stake is not a price difference. It is the whole principal amount.
Together the two make up counterparty risk, which arises if one party to the contract does not honour it and fails to discharge its obligation fully and on time.
And there is a clean cure. A central counterparty standing in the middle, through the principle of novation.
How it works
The parent and its two halves. Counterparty risk arises if one of the parties to the commodity derivatives contract does not honour the contract and fails to discharge their obligation fully and on time. It broadly has two components:
| Component | When it arises | What is at risk |
|---|---|---|
| Replacement cost risk (pre-settlement risk) | before settlement | the cost of replacing the original trade, since the new trade may be done at a different and probably adverse price |
| Principal risk | during settlement | the whole amount already paid or the goods already delivered |
How it is eliminated. Principal risk is eliminated by having a central counterparty such as a clearing corporation, and through the principle of novation. The clearing corporation becomes the counterparty to both sides, so neither party is exposed to the other's failure.
The qualification that is the real examinable point. SEBI has recognised that commodity exchanges need not be the other counterparty for gross settlement of the full amount in case of default by the other counterparty. Exchanges guarantee financial settlement and not gross delivery settlement — that is, they can guarantee the financial compensation to the aggrieved party in case of default by the other counterparty.
So money is protected, and goods are not. A buyer whose assigned seller defaults on delivery gets compensated in cash, not in maize.
The front-line control. Transactions involving transfer of ownership of commodities are settled on a delivery-versus-payment (DVP) basis, by netting at a client level and grossing up at the member level, while fund obligations are netted at the member level. DVP is what is supposed to stop one leg happening without the other in the first place.
The remedy when it does crystallise on a delivery. SEBI's delivery default norms put the penalty on the defaulting seller. For futures contracts on agri-commodities it is 4% of the Settlement Price plus replacement cost, where replacement cost is the difference between the settlement price and the average of the three highest of the last spot prices of the 5 succeeding days after the commodity pay-out date — and that component is zero if the average so determined is not higher than the settlement price. Behind all of it sits the Settlement Guarantee Fund.
The principal risk passage itself carries no figure. The 4% and 5-day figures above belong to the penalty that answers a realised default, not to the definition of the risk.
A worked example
Ganga Traders sells 4 lots of a 10 MT contract — 40 MT, or 400 quintals — at Rs 6,000 per quintal.
Contract value = 400 x 6,000 = Rs 24,00,000
Two different failures, on the same contract.
| Case A — replacement cost risk | Case B — principal risk | |
|---|---|---|
| When | before settlement | during settlement |
| What happened | the counterparty defaults; Ganga must replace the trade | Ganga has already delivered the 40 MT; the buyer fails to pay |
| Market at the time | Rs 6,250 per quintal | Rs 6,000 per quintal |
| Loss | (6,250 - 6,000) x 400 = Rs 1,00,000 | the whole Rs 24,00,000 |
The second loss is 24 times the first, on an identical position. That ratio is the entire reason principal risk gets its own name and its own cure.
And it is Case B that the clearing corporation removes. Through novation, the clearing corporation is Ganga's counterparty, so Ganga's receivable is from the clearing corporation and it is paid. Margin does not achieve this; margin reduces Case A.
Now the qualification, from the other side. Suppose instead Ganga is the buyer, has paid, and the assigned seller fails to deliver the 40 MT. The exchange guarantees financial settlement, not gross delivery settlement. So Ganga receives financial compensation under the delivery default norms rather than the commodity. On an agri contract the penalty on the defaulting seller starts at 4% of the settlement price:
4% of Rs 24,00,000 = Rs 96,000, plus replacement cost where the succeeding spot prices ran above the settlement price.
A processor who needed those 40 MT to keep a plant running now has Rs 96,000 and no maize. The money risk was novated away; the delivery risk was not.
Why NISM asks about it
Chapter 7 (Clearing, Settlement and Risk Management), section 7.8.1 on counterparty risk and section 7.8.2 on principal risk, which open the chapter's risk management discussion. Section 7.6 supplies the delivery default penalty that answers a realised default.
Expect: counterparty risk has two components — replacement cost risk, also called pre-settlement risk, and principal risk, which arises during settlement; and principal risk is eliminated by — a central counterparty such as a clearing corporation, through the principle of novation. The chapter's own sample question offers principal risk as one of the options. The discriminating point is SEBI's qualification that exchanges guarantee financial settlement and not gross delivery settlement.
Common exam traps
- Two components, and only one is pre-settlement. Replacement cost risk is pre-settlement; principal risk arises during settlement.
- Principal risk is the loss of the whole amount, not a price difference. That is what principal means here, and it is what makes it the graver of the two.
- Novation eliminates it; margin does not. Margin addresses replacement cost risk. It is the central counterparty and novation that remove principal risk.
- The guarantee is financial, not physical. Exchanges guarantee financial settlement and not gross delivery settlement, so an aggrieved buyer receives compensation rather than the goods.
- Do not confuse the three similar names. Replacement-cost risk is the pre-settlement component; replacement cost is a defined input to the delivery default penalty; principal risk is the settlement component.
- DVP is a mechanism, not a component. Delivery-versus-payment is how the two legs are kept together; it is not one of the two parts of counterparty risk.
- It is not operational risk. The workbook defines that separately as loss from inadequate or failed internal processes, people and systems, or from external events such as error, fraud and outages.
- The definition carries no figure. The 4% penalty and the 5-succeeding-day window belong to the delivery default norms, not to principal risk itself.
Check yourself
1.Transactions involving transfer of ownership of commodities are settled on which basis?
- a)Cash settlement
- b)Auction settlement
- c)Margin settlement
- d)Delivery-versus-payment
Show the answer
Answer: (d) Delivery-versus-payment
(This is a sample question from the NISM workbook.)
"Transactions involving transfer of ownership of commodities are settled on DELIVERY-VERSUS-PAYMENT (DVP) BASIS BY NETTING AT A CLIENT LEVEL AND GROSSING UP AT THE MEMBER LEVEL, whereas FUND OBLIGATIONS ARE NETTED AT THE MEMBER LEVEL to reduce the number of settlement transactions."
The netting asymmetry in that sentence is worth as much attention as the DVP answer itself, because it is separately examinable:
Netting level ⚠️ Commodities Netted at CLIENT level, then GROSSED UP at member level ⚠️ Funds Netted at MEMBER level The reason is physical. Two different clients of the same broker each need their own goods delivered to their own account, so commodity obligations can only net within a client and must then be added together. Money has no such identity — a rupee owed by one client offsets a rupee owed to another perfectly, so funds net all the way up.
DVP is what makes settlement safe: goods and money move against each other simultaneously, so neither side has to perform first. This is the same idea as novation — "principal risk is ELIMINATED BY HAVING A CENTRAL COUNTERPARTY such as a clearing corporation."
2.Which risk refers to the cost of substituting an original trade with a new trade, as the new trade may be done at a different and probably adverse price to the aggrieved party?
- a)Rollover risk
- b)Principal risk
- c)Replacement-cost risk
- d)Systemic risk
Show the answer
Answer: (c) Replacement-cost risk
(This is a sample question from the NISM workbook.)
"REPLACEMENT-COST RISK refers to THE COST ASSOCIATED WITH REPLACING THE ORIGINAL TRADE, as the new trade MAY GENERALLY BE DONE AT A PRICE DIFFERENT FROM THE ORIGINAL PRICES AND PROBABLY AT AN ADVERSE PRICE TO THE AGGRIEVED PARTY."
It is also called pre-settlement risk, and it is one of the two components of counterparty risk:
Component When it bites ⚠️ Replacement-cost (pre-settlement) Before settlement — the trade fails and must be redone at a worse price ⚠️ Principal ⚠️ During settlement — "arises when the buyer/seller HAS NOT RECEIVED THE GOODS/FUNDS BUT HAS FULFILLED HIS OBLIGATION" Option (b) principal risk is therefore the near-miss — and it is the one the market has genuinely solved: "ELIMINATED BY HAVING A CENTRAL COUNTERPARTY such as clearing corporation and through the principle of NOVATION." Replacement-cost risk cannot be eliminated the same way; it is instead compensated, through the replacement cost component of the delivery default penalty.
Option (d) systemic risk is broader — "the default by one of the parties LEADS TO THE DEFAULT OF OTHER PARTIES TOO... THE MULTIPLIER EFFECT."
Where this is taught
Free preparation for NISM Series XVIRelated terms
- NovationThe clearing corporation stepping into the middle of every trade — becoming the buyer to every seller and the seller to every buyer — so that neither side carries the other's default risk.
- Central counterpartyThe clearing corporation that interposes itself in every exchange trade, becoming buyer to every seller and seller to every buyer, so neither side carries the other's credit risk.
- ClearingThe daily accounting step that reconciles what every party owes and is owed on its open and closed positions, and turns a day of trades into one net obligation per member.
- SettlementThe step where the obligations computed by clearing are actually discharged — commodities against funds on a delivery-versus-payment basis, or cash against the settlement price.
- Systemic riskThe risk that one participant's default triggers defaults by others until the settlement system itself fails — the domino risk, not the market risk.
- Compulsory deliveryA delivery logic under which every position still open at expiry must give or take physical delivery — neither side can elect to settle in cash.
- Delivery default penaltyThe SEBI-prescribed charge on a seller who fails to deliver against an expiring contract — a fixed percentage of the settlement price plus a replacement cost, most of which is paid over to the buyer.
- Replacement costThe part of a seller's delivery-default penalty measured against the market — the gap between the settlement price and the actual spot price the non-defaulting buyer would need to pay to replace the missed delivery.
- Replacement-cost riskThe pre-settlement half of counterparty risk — the cost of having to replace a defaulted trade, usually at a worse price than the original, before settlement was ever due.
- Settlement Guarantee FundA fund held by the clearing corporation, built from contributions by the exchange, the clearing corporation and clearing members plus a share of settlement penalties, used to complete settlement if a member defaults.