Replacement cost
Also written Replacement cost component
The 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.
In plain language
When a seller who owes delivery on a commodity futures contract fails to deliver, the buyer who was supposed to get the goods is left short. He now has to go and buy the same commodity somewhere else, probably at a worse price than he had locked in.
The replacement cost is the workbook's name for that gap — the extra amount the wronged buyer would have to pay to replace the delivery he did not get. SEBI's delivery-default penalty is built to compensate for exactly this, on top of a flat percentage penalty.
How it works
For agri-commodity futures, the seller's default penalty is 4 per cent of the Settlement Price plus replacement cost. Here, replacement cost is the difference between the Settlement Price and the average of the three highest of the last spot prices over the 5 succeeding days after the pay-out date — but only if that average is higher than the Settlement Price. If it is not higher, this component is zero.
For non-agri commodity futures, the penalty is 3 per cent of the Settlement Price plus replacement cost, where replacement cost is the difference between the Settlement Price and the higher of the last spot price on the pay-out date and on the following day — again zero if that spot price is not higher than the Settlement Price.
Of the amount collected, at least 1.75 per cent of the Settlement Price goes to the Settlement Guarantee Fund, up to 0.25 per cent may be kept by the Clearing Corporation for administration, and the balance — 1 per cent for non-agri, 2 per cent for agri — plus the whole replacement cost component goes to the wronged buyer.
A worked example
A seller defaults on delivery of a non-agri commodity futures contract with a Settlement Price of Rs 60,000 per unit. The spot price on the pay-out date is Rs 61,500 and on the following day is Rs 62,000 — the higher of the two is Rs 62,000.
Replacement cost = Rs 62,000 - Rs 60,000 = Rs 2,000 per unit.
Total penalty on the seller = 3% of Rs 60,000 + Rs 2,000 = Rs 1,800 + Rs 2,000 = Rs 3,800 per unit. Of this, roughly Rs 1,050 (1.75% of Settlement Price) goes to the Settlement Guarantee Fund, up to Rs 150 (0.25%) may be retained by the Clearing Corporation, and the remaining Rs 600 (1% of Settlement Price) plus the full Rs 2,000 replacement cost, totalling Rs 2,600, goes to the buyer who did not receive delivery.
Why NISM asks about it
Chapter 7 (Clearing, Settlement and Risk Management), section 7.6, "Penalty for Seller's Delivery Default and Buyer's Default." Expect a calculation question building the total penalty from the flat percentage and the replacement cost component, and a trap on which spot-price window applies to agri versus non-agri goods.
Common exam traps
- Agri and non-agri use different flat percentages (4% vs 3%) and different spot-price windows for replacement cost — five succeeding days' average-of-three-highest for agri, pay-out day and the next day's higher for non-agri.
- Replacement cost is zero, not negative, if the reference spot price is not higher than the Settlement Price. It never reduces the penalty.
- Replacement cost goes entirely to the buyer, on top of his share of the flat percentage penalty — it does not get split with the Settlement Guarantee Fund.
- Do not confuse this with the "Replacement Cost Approach" used in business valuation — that is an unrelated concept about valuing a company by what it would cost to rebuild it.
Check yourself
1.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."
2.Of the 4 per cent penalty levied on a seller who defaults on delivery of an agri commodity, how much goes to the buyer entitled to receive delivery?
- a)The whole 4 per cent plus replacement cost
- b)2 per cent of settlement price plus the replacement cost
- c)1.75 per cent of settlement price only
- d)0.25 per cent of settlement price plus replacement cost
Show the answer
Answer: (b) 2 per cent of settlement price plus the replacement cost
The apportionment rule:
Recipient ⚠️ Share Settlement Guarantee Fund ⚠️ AT LEAST 1.75% of settlement price Clearing Corporation (administration) ⚠️ UP TO 0.25% of settlement price ⚠️ The buyer entitled to delivery ⚠️ The balance — 2% for agri, 1% for non-agri — PLUS THE REPLACEMENT COST "BALANCE AMOUNT (i.e. 1% OF SETTLEMENT PRICE IN CASE OF NON-AGRI GOODS OR 2% OF SETTLEMENT PRICE IN CASE OF AGRI GOODS) PLUS REPLACEMENT COST SHALL GO TO THE BUYER WHO WAS ENTITLED TO RECEIVE DELIVERY."
Check the arithmetic both ways: agri 4% = 1.75 + 0.25 + 2 and non-agri 3% = 1.75 + 0.25 + 1. The SGF and administration slices are identical in both cases — so the entire agri/non-agri difference flows to the buyer.
And note that the whole replacement cost goes to the buyer too, which is right: he is the one who must now go into the market and buy the goods at whatever price prevails.
The replacement cost is measured differently for the two:
- ⚠️ AGRI: the difference between settlement price and THE AVERAGE OF THREE HIGHEST OF THE LAST SPOT PRICES OF 5 SUCCEEDING DAYS after the commodity pay-out date
- ⚠️ NON-AGRI: the difference between settlement price and THE HIGHER OF THE LAST SPOT PRICES ON THE PAY-OUT DATE AND THE FOLLOWING DAY
In both cases, "IF the price so determined IS HIGHER THAN SETTLEMENT PRICE, ELSE THIS COMPONENT WILL BE ZERO."
Clearing corporations may also "increase/decrease penalty for specific commodities... IN CONSULTATION WITH SEBI", and may add "PENAL/DISCIPLINARY ACTION against INTENTIONAL/WILLFUL DELIVERY DEFAULT."
3.If a client fails to deliver against a sold position, what may the member do?
- a)Nothing — the exchange handles all delivery failures
- b)Purchase the commodity from the client's account and debit the client, or square off the client's position provided the client was already intimated separately or through the client agreement
- c)Retain the client's entire margin as a penalty without further action
- d)Report the client to the FIU and suspend the account permanently
Show the answer
Answer: (b) Purchase the commodity from the client's account and debit the client, or square off the client's position provided the client was already intimated separately or through the client agreement
The condition attached to the second alternative matters. Squaring off without prior intimation would expose the member to a complaint for "SQUARING UP OF POSITIONS WITHOUT CONSENT" — one of the nine grievances the exchange entertains. The intimation may be given at the time or built into the client agreement in advance, but it cannot be dispensed with.
The related right in the same list: ⚠️ "To HOLD THE COMMODITIES PURCHASED FOR THE CLIENT, WHICH ARE SUPPOSED TO BE DELIVERED TO HIM, FOR ADJUSTING AGAINST RECEIVABLES FROM THE CLIENT IN CASE OF DISPUTE OR PAYMENT DEFAULTS."
And the preventive rights that come earlier: a member may "NOT DEAL in a transaction if aware about FAILURE IN COMMITMENT BY THE CLIENT IN OTHER DEALS, or there is SHORTFALL IN MARGIN — including NOT TAKING FRESH POSITIONS depending upon the RISK PROFILE OF THE CLIENT, OR UPON CLIENT'S HISTORY OF PAYMENT DEFAULTS/DELAYS", and may "LEVY ADDITIONAL MARGINS from certain clients or certain trades depending upon risk profile."
Option (a) confuses two layers. The exchange and clearing corporation deal with the member's obligation and levy the delivery default penalty — 4% for agri, 3% for non-agri, plus replacement cost. But between member and client, the member has its own contractual remedies, and it is the member who must make good to the clearing corporation in the first place.
Where this is taught
Free preparation for NISM Series XVIRelated terms
- Final Settlement PriceThe price at which a commodity derivative is finally settled at expiry — a simple average of the polled spot prices of the expiry day and the two days before it.
- 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-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.
- Book value per shareEquity shareholders' funds as per the balance sheet divided by the number of equity shares issued and paid up — normally treated as the floor value of a going-concern business.
- Principal riskThe 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.