Settlement averaging period: Overview, definition, and example
What is the settlement averaging period?
The settlement averaging period refers to the time frame over which prices or values are averaged to determine the final settlement price or value in a financial transaction, such as a commodity contract, derivatives contract, or security trade. This period is used to calculate the average price of an asset, commodity, or index over a set period before the final settlement is made.
For example, in futures or options contracts, the settlement averaging period may be used to determine the final settlement price of a contract, based on an average of the asset's price over a specific period, rather than relying on a single day’s closing price. The averaging period reduces the impact of price volatility on the settlement value and can help provide a more accurate and fair price for the transaction.
Why is the settlement averaging period important?
The settlement averaging period is important because it helps to mitigate the risk of price fluctuations or volatility on the final settlement price of a contract or trade. By averaging prices over a period, the effect of any sudden market movements on a single day is reduced, leading to a more balanced and representative settlement price.
This is especially important in markets with high volatility, as it provides a way to smooth out short-term price spikes or drops, ensuring that both parties in a contract or trade are treated fairly and equitably. It also helps ensure that the settlement price reflects a broader trend over time rather than reacting to short-term market fluctuations.
Understanding the settlement averaging period through an example
Imagine an investor holds a futures contract on oil, and the contract specifies a settlement averaging period of 10 days. Over these 10 days, the price of oil fluctuates daily. At the end of the 10-day period, the average price of oil over that time is calculated, and that average price is used as the settlement price for the contract.
If oil’s price is very volatile on a single day but remains relatively stable over the course of the 10-day period, the averaging period ensures that the extreme fluctuations of that one day don’t disproportionately affect the settlement price. The final settlement price will be the average of the 10 days, offering a more stable and fair price for both parties in the transaction.
Example of a settlement averaging period clause
Here’s how a settlement averaging period clause might appear in a contract:
“The final settlement price of the contract shall be determined by calculating the average price of the underlying asset over a period of 15 consecutive trading days, ending on the last day of the settlement period. The final settlement price will be the arithmetic average of the daily closing prices of the asset during this period.”
Conclusion
The settlement averaging period is a crucial mechanism used in various financial contracts to determine a fair and stable settlement price by averaging prices over a set period. This process helps reduce the impact of short-term volatility or market fluctuations, ensuring that both parties in the transaction receive a more balanced settlement. By smoothing out the effect of extreme price movements, the settlement averaging period ensures that pricing is representative of broader trends and is less likely to be skewed by temporary market conditions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.