Static and dynamic margin: Difference between revisions

Where you have a “[[Bullet swap|bullet]]” [[TRS]], being a [[delta-one]] [[equity derivative]] with a specified termination date, usually one or two years from inception, [[Initial margin]] would be calculated based on the notional value of the swap at inception and the estimated life of the trade and the expected volatility during that period. Once set, the broker could not change initial margin, unless there were pre-agreed {{eqderivprov|Equity Notional Reset}}s.  It would always reflect that initial [[Strike Price - Equity Derivatives Provision|strike price]], and would not adjust to reflect the changing value of the [[underlier]]. This means, as the swap value went up, the relative value of the posted initial margin, proportionately, went ''down''. Fifteen per cent initial margin at 100 is the same as 7.5% initial margin if the underlier appreciates to 200.

Now, you might say, the client is making money! Why should he have to pay ''more'' initial margin where his trades are in the money? Surely there is now a buffer not of fifteen, but ''one hundred and fifteen'' before the broker is facing a loss!

Well, because of [[variation margin]]. If a position appreciates by 100%, the [[broker]] must pay out, in cash, the total value of the gain as [[variation margin]]. If you view an equity swap as a margin loan done with derivatives, the broker took in 15 on day 1, used 85 of its own money to buy 100 of the stock as a hedge, and has now paid out another hundred to the client. So the economics of the margin loan are now: loaned 185, received margin 15.  

Increasingly, it seemed [[delta-one]] equity swap clients were not really looking for bullet exposures — the term is kind of arbitrary — but really wanted to replicate a margin loan with a physical holding of the stock, that they could sell, or not sell, at any time. Hence was born the synthetic equity swap — sometimes known as a “portfolio master confirmation”, a “portfolio swap annex”, a “PRT”, an “SES”, or some other confection — which presumed the client would hold the position indefinitely, and thus allowed the broker to reassess its margin at any time, and also reference the initial margin to the prevailing {{eqderivprov|Final Price}}, not the {{eqderivprov|Initial Price}}, thereby dynamically adjusting margin on the fly, and without uncomfortable calls to the client to explain ''why''.