When variation margin attacks: Difference between revisions

It did not take long for folks to realise that these new swap things presented a whole new class of risks.<ref name="fwmd"/> Swaps provide unfunded exposure to assets — you don’t have to put down any cash up front — and if you trade in any great frequency, your total notional can quickly blow out of all proportion, especially given the typical notional size of individual swap transactions, which was in the millions of dollars. The market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]].

We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the present value of the opposing legs of an individual swap to give yourself a [[mark-to-market]] value for that single swap, which could be positive or negative, so too could you offset opposing positive and negative [[mark-to-market]] values for individual swaps traded under a [[single agreement|single master agreement]] to arrive at a single net exposure for the whole {{isdama}}. This was a stroke of genius, and the brave commandos of {{icds}} encoded this [[single agreement]] concept into the {{1987ma}} and its successors. Enough said.

Now, even having applied set-off and netting, either side of a swap contract could still be left with a large, volatile exposure. The exposure could move by hundred of millions of dollars in a single day, and could flip in or out-of-the-money quite suddenly.

The solution, which arrived a decade or so after derivatives trading started in earnest, was something called a “[[credit support annex]]” to the {{isdama}}. Under this arrangement, the parties could require set [[initial margin]], and also exchange variation margin reflecting the prevailing exposure under the agreement. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref> but the gist of it was that either side could calculate its net exposure on a day and require the other side to post credit support — usually in the form of bonds or liquid securities — to it to hold as collateral for that exposure.