What is Settlement Price?
What is Settlement?
Settlement is the final exchange of money and securities on the settlement date between the parties to a contract after the transaction has been agreed upon previously. Settlement in a derivatives contract is of two types namely Daily Settlement & Final Settlement. The daily settlement is done using the Mark-to-Market (MTM) procedure whereas the final settlement is done using the closing price at expiry.
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MTM settlement:
All contracts for each member are marked-to-market (MTM) to the daily settlement price of the relevant futures contract at the end of each day. The profits/losses are computed as the difference between the trade price and the day’s settlement price for contracts executed during the day but not squared up.
What is Settlement Price?
The settlement price is often confused with a closing price however these are disparate. It is cardinal to investors & traders, it is the price used for closing positions and settling contracts at the expiry date. Trades that the bank holds in the trading books are Marked-to-Market at the end of each trading day to compute PnL for the given trading day. MTM is done comparing open positions with settlement price and this procedure is known as Daily settlement. According to MTM value Margin is posted/withdrawn from trading accounts based on PnL of the day. (Margin money is the fraction of contract value arrived at using MTM posted in a trading account). MTM helps arriving at conclusion whether a position at the end of the day is:
- a) In the Money (ITM) OR
- b) Out of the Money (OTM) OR
- c) At the Money (ATM)
How it is computed?
Settlement price though skewed towards closing price however for indices is a weighted average of prices of trades taking place in the last hour of the day (& for individual securities, it is simply closing price). Time periods could differ based on regions and exchanges. It is an average of the prices at which trades happen in the last hour considering the volume of the trades.
Although opening and closing prices are typically treated in the same manner from one exchange to the next, there is no protocol for how to evaluate settlement prices in different markets, resulting in global market variances. There isn’t one acceptable standard price across, settlement price could differ for the same contract based on computation method, the time period considered, and other intricacies.
Below is the simple example of how it is computed, it could be observed based on below table volumes skew settlement price i.e. the price at which the highest qty of trade takes place becomes the mean for settlement price and our settlement price could be +/- 1 std deviation:
In some cases, prices might be considered across the day, and not just in the last trading hour, this is generally the case when bulk deals with institutional clients take place. Such gigantic deals have volumes in millions and hence are considered for the computation.
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Conclusion:
- The settlement price plays important role in daily PnL computation.
- The price for the same contracts can vary across regions & exchanges.
- It is skewed based on the trade volumes (for indices).
Author: Varsha Bhambhani
About Author: I’m an FRM professional and CFAL-2 candidate with 3 yrs of work ex in the risk domain. My interest includes mathematics and finance. From a personal life perspective, I love health and fitness, in not studying one can find me inside the gym aka nerd gym rat.
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