Replacement-cost risk
Also written Pre-settlement risk
The 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.
In plain language
Counterparty risk is not one single thing. The workbook splits it into two pieces, and replacement-cost risk is the first of them.
It is the risk that arises before settlement is even due — while the trade is still open. If the other side of the trade fails at this stage, the non-defaulting party has to go back into the market and put on a fresh trade to replace it. Markets move, so that replacement trade is usually done at a less favourable price than the original one. That price gap is the loss replacement-cost risk describes.
How it works
Chapter 7, section 7.8.1, defines counterparty risk as having two components: replacement-cost risk, which is pre-settlement, and principal risk, which arises during settlement itself. Replacement-cost risk is specifically "the cost associated with replacing the original trade," because the new trade is generally done at a price different from — and probably adverse to — the aggrieved party.
This is distinct from principal risk, which the workbook defines separately as the risk that a buyer or seller has paid or delivered but not received the matching goods or funds in return. Exchanges manage principal risk by interposing a central counterparty and using novation; replacement-cost risk is managed mainly through margining, so that the aggrieved party has funds on hand to absorb the cost of the replacement trade.
A worked example
A trader is long 10 lots of copper futures at Rs 780 per kg, with his counterparty obligated to deliver copper to him in three weeks. Before delivery is due, that counterparty defaults and its open position is closed out by the clearing corporation.
Copper has since moved to Rs 800 per kg. To keep the same market exposure he had before, the trader must now buy a fresh 10-lot position at Rs 800 per kg instead of the Rs 780 he originally locked in — a replacement cost of Rs 20 per kg, or roughly Rs 5,00,000 on a 25-tonne (10-lot) position, before any margin the clearing corporation applies to cover exactly this exposure.
Why NISM asks about it
Chapter 7 (Clearing, Settlement and Risk Management), section 7.8.1, "Counterparty Risk," which splits the concept into replacement-cost risk and principal risk right at the start of the risk-management discussion. Expect a question testing which of the two is the pre-settlement risk, and which is the risk of one-sided performance during settlement.
Common exam traps
- Replacement-cost risk is pre-settlement; principal risk arises during settlement. Mixing up the timing is the most common error.
- This is a different "replacement cost" from the one in the seller's delivery-default penalty formula — that is a specific rupee figure in a penalty calculation; this is the broader risk category the margining system exists to cover.
- Novation and a central counterparty address principal risk, not replacement-cost risk, which is instead managed through margining.
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.Some exchanges limit how much of their exposure can be backed by bank guarantees from any single bank. The workbook describes this as a proactive step against which risk?
- a)Systemic risk
- b)Legal risk
- c)Operational risk
- d)Replacement-cost risk
Show the answer
Answer: (a) Systemic risk
The workbook's words, under Systemic Risk: "Systemic risk might arise when THE DEFAULT BY ONE OF THE PARTIES LEADS TO THE DEFAULT OF OTHER PARTIES TOO... SOME OF THE EXCHANGES ALSO HAVE LIMITS TO EXPOSURE TO BANK GUARANTEES OF A SINGLE BANK which is an example of exchanges proactive attempts to PREEMPT SYSTEMIC RISKS that may arise due to the bank's financial woes." So option (a) is right.
The reasoning: if many members' margins were backed by guarantees from one bank, that bank's failure would leave many members short of margin at the same moment. One failure would spread across the system.
Why the others are wrong:
- (b) Legal risk comes from "uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations". The workbook's examples are the Essential Commodities Act and FSSAI standards, plus GST and CTT.
- (c) Operational risk is "loss resulting from inadequate or failed internal processes, people and systems, or from external events". The workbook's examples are connectivity problems, trading-engine hang-ups and sun outage.
- (d) Replacement-cost risk is the cost of replacing a defaulted trade at a worse price.
Other systemic-risk defences named in the workbook: "stricter rules and regulations on margining, capital adequacy standards, settlement guarantee funds and legal backing for settlement activity."
Where this is taught
Free preparation for NISM Series XVIRelated terms
- 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.
- 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.
- 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.
- 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.