Replacement Risk

Replacement risk is a risk that may be present in over the counter and alternative derivative market trading. In alternative derivative markets, there is typically no regulatory authority supporting the execution of a derivative contract. Some alternative derivative markets may include contractual clauses to reduce the risk of default by a counterparty. Replacement risk may also be known as counterparty risk.

Replacement risk can include any type of risk or cost to an entity in the case of an alternative derivative market default or any contracted agreement in which one party is unable to fulfill their contractual obligation. Replacement risk is generally an important concern in alternative derivative markets since these markets require delivery by a counterparty at execution and they are not backed by any regulatory funding. Replacement risk is alleviated in public market derivatives trading because the Options Clearing Counsel (OCC) and Commodity Futures Trade Commission (CFTC) step in when there is a default and provide the needed funding for transaction execution.

There are numerous derivative exchanges across the U.S. and internationally that list public market derivatives for regulated trading. These exchanges include the Chicago Board of Trade, Chicago Board Options Exchange, Chicago Mercantile Exchange, New York Mercantile Exchange, New York Board of Trade and many more. These exchanges are backed by the support and regulatory authority of the OCC and CFTC.

Brokers and regulated public market derivative exchanges are required to register and follow the regulations of the OCC, CFTC and other regulators. The OCC and CFTC support the regulated public derivative exchanges with rules and regulations on operational procedures. They also provide funding for any derivative market transactions where a counterparty is unable to fulfill their obligation. For example, if a call option owner exercises their option to buy shares and the counterparty on the opposite side cannot provide the shares, the OCC will cover the counterparty to ensure that the transaction is executed.

Alternative derivative market exchanges are actively traded and include a great deal of trading from institutional investors. Institutional investors generally deploy more complex derivative trading on these markets with more complex derivative contracts. Since these market exchanges are not supported by a regulated authority, replacement risk can be an important factor for consideration.

Many alternative market institutional investors will include provisions in their derivative contracts to protect against the risk of default from a counterparty. If default occurs, alternative market derivative investors may incur replacement costs or losses associated with a contract that cannot be fulfilled.

For example, if a counterparty in an alternative stock option contract is unable to fulfill its contractual obligation when an option is exercised, the exercising entity will have to replace the stock it expected to receive or write-off the stock as a loss.