What is Novation?
- Novation is the process of intervening in a contract whereby it acts as a middleman by entering the contract where the concerned parties mutually agree to allow it to intervene.
- It is a process whereby one of the two initial contracting parties is replaced by an entirely new party, whereby the original party willingly agrees to forgo any rights originally afforded to him.
- A novation is not a unilateral contract mechanism; therefore, all concerned parties may negotiate the terms of the replacement contract until a consensus is reached.
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In Financial Markets:
- In the Derivatives market, novation refers to an arrangement whereby more than one transaction is done through a clearinghouse which therein functions as a middleman.
- Novation is used in futures and options trading to describe a special situation where the central clearing house intervenes between the buyer and seller as a legal counterparty that is the clearinghouse.
- The clearinghouse becomes the buyer to every seller and becomes a seller to every buyer. This satisfies the need for the verification of the creditworthiness of both the buyer and seller.
- The only Credit risk which both the counterparty participants face is the credit risk of the clearinghouse defaulting.
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Novation Explained with Example:
- Trader A enters into a futures contract with Trader B in crude oil. Trader A is long in the sense that he is expecting that the price will be higher by the end year while Trader N is short in the sense that he is expecting that the price will be lower by the end year.
- Thus, Trader A goes long on crude oil futures while Trader B goes short in crude oil futures. Thus, they enter into a December crude oil futures contract. Thus, in order to ensure the certainty of both the counterparty, novation takes place.
- The clearinghouse intervenes and thus both the traders need to keep margin requirement say a part of their trade-in futures, with the clearinghouse so as to ensure the certainty of both the parties.
- When the futures are traded and both the parties settle upon their trade by netting out, the margin is either set off or is returned to the respective parties.
AUTHOR: Bhagyashree Chandak
About the Author: I aspire to become a research analyst and earn and use the best of my knowledge.