Variation Margin
Variation Margin the cash transfer that takes place after each trading day (and sometimes intraday) in most futures markets to mark long and short positions to the market. Unlike a forward contract that settles only when the contract matures, most futures contracts are settled daily by the payment of variation margin from the party who has lost money that day to the party who has made money.
If each point in the price of a contract is worth $1,000, and the futures price goes up by 1/2 point during a session, the short will pay the long $500 per contract in variation margin. Holders and sellers of futures options do not exchange variation margin under current margin procedures, but the ability to capture accumulated variation margin payments through affects the value of an American-style futures option[1].
All financial futures positions are marked to market on a daily basis. Where such procedures result in a net profit or loss situation per futures contract position, settlement between the ultimate position holding member or client and the clearing house takes place in the form of payments which in this case is termed variation margin[2].
Arrangement of variation margin
Transactions in the money market expose the cash-lending party to credit risk and repo is no exception to this. The presence of security may be viewed as reducing the inherent credit risk exposure; however, it does not remove the need for credit assessment and know your counterpart. A bank will assess each counterparty for its creditworthiness, as well as the quality of the collateral, and assign a net repo trading limit (net of repo and reverse repo). A margin rate will be agreed on the basis of this assessment. In classic repo, as traded under the GMRA master agreement, this includes initial margin and ongoing variation margin.
A variation margin arrangement will include[3]:
- daily marking-to-market of each stock that has been accepted as repo collateral. If there is a standard reference price this will be taken as the mark, otherwise a third-party price source will be used
- the level at which variation will be called, that is the threshold level below the initial margin point
Problem with variation margin
It can argued that variation margin in not completely free and without additional liquidity risk for two reasons[4]:
- First, variation margin must be paid in relatively liquid securities or cash (indeed, CCPs typically allow only the latter) whilst some market participants will have access only to illiquid non-eligible assets. For example, consider an airline hedging its exposure to the price of aviation fuel via an oil swap or forward contract. The airline will make (lose) money on those hedges in the event of high (low) prices, which will be balanced economically by higher (lower) fuel costs over the period of the hedge.
- A second problem with variation margin is the inherent delay caused by non-immediate posting (which can be days or at least hours). This interrupts the flow of variation margin through the system and causes funding liquidity risk. This effect will be particularly strong in volatile markets and even more so when there is a large asset price shock. Furthermore, central counterparties have a privileged position with respect to margin exchange and may therefore interrupt margin flow significantly for their own benefit.
Examples of Variation Margin
- An example of variation margin is when a trader has a long position in a futures contract. On any given day, the value of the contract can go up or down. If the contract value goes down, the trader must make a payment to the counterparty to cover the difference between the current value of the contract and the value of the contract at the start of the day. This is the variation margin.
- Another example of variation margin is when a trader has a short position in a futures contract. If the value of the contract goes up during the day, the counterparty must make a payment to the trader to cover the difference between the current value of the contract and the value of the contract at the start of the day. This is also variation margin.
- A final example of variation margin is when a trader has a position in an options contract. If the value of the contract changes during the day, the trader must make a payment to the counterparty to cover the difference between the current value of the contract and the value of the contract at the start of the day. This is also variation margin.
Advantages of Variation Margin
Variation Margin is an important tool in futures markets that helps to ensure the smooth functioning of the market. It provides a number of advantages, including:
- Improved risk management: Variation margin helps to reduce credit risk and counterparty risk by requiring traders to post additional margin money when their positions become too large. This ensures that traders are able to cover any losses that may occur during the trading day.
- Faster liquidation: Variation margin helps to ensure that any losses can be quickly liquidated, reducing the risk of further losses. The quicker liquidation process also helps to improve market efficiency.
- Increased transparency: Variation margin helps to ensure that traders are aware of their positions and any potential losses, helping to create a more transparent market. This also helps to reduce any potential conflicts of interest between traders.
Limitations of Variation Margin
Variation margin is an important tool for mitigating risk in futures markets; however, it does have certain limitations. These include:
- Variation margin cannot guarantee against losses; only against the possibility of a counterparty defaulting on their obligations.
- Variation margin only applies to futures contracts and not to other derivatives or financial instruments.
- Variation margin may be insufficient to cover potential losses in certain circumstances, such as when there is a rapid and significant movement in the market.
- Variation margin is not automatically adjusted to reflect changes in the market. The parties must agree to adjust the amount of margin required as the market moves. This can lead to a situation where one party is under-margined and potentially exposed to a greater risk of loss.
- Variation margin does not cover losses incurred due to market volatility or other risks associated with trading futures contracts.
Variation Margin is an important part of the futures market, which helps to ensure that positions are marked to market daily. Other approaches related to Variation Margin include:
- Initial Margin - The initial margin is the amount of capital that must be deposited in order to open a position. It is usually set by the exchange and is designed to cover potential losses that could occur if the market moves against the position.
- Risk Management Margin - Risk management margin is a type of margin that is designed to protect against abnormal market conditions. It is usually set higher than the initial margin and is used to cover potential losses that could occur if the market moves abnormally.
- Maintenance Margin - Maintenance margin is the minimum amount of capital that must be maintained in order to keep a position open. If the margin account balance falls below the maintenance margin, the position will be closed.
In summary, Variation Margin is a cash transfer that takes place after each trading day to mark long and short positions to the market, and there are several other related approaches such as Initial, Risk Management, and Maintenance Margin. These approaches are designed to help ensure that positions are adequately covered and managed.
Footnotes
| Variation Margin — recommended articles |
| Cross margining — Liquidity risk — Translation Risk — Margin level — Interest Rate Collar — Basis swap — Asset swap — Life Cap — Buying Hedge |
References
- Choudhry M., (2010), The Repo Handbook, Butterworth-Heinemann, Boston.
- Gastineau G.L., Kritzman M.P., (2005), Dictionary of Financial Risk Management, John Wiley & Sons, New York.
- Gregory J., (2014), Central Counterparties, John Wiley & Sons, New Jersey.
- Parker P., (2010), Mastering the ACI Dealing Certificate, Pearson Education, Toronto.
Author: Marlena Dopnik
