Static and dynamic margin
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Equity Derivatives Anatomy™
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A technique that achieved some notoriety in the aftermath of the Archegos meltdown, but in the good old innocent days of TRS, especially before compulsory variation margin, was really rather run-of-the-mill.
Where you have a “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 Equity Notional Resets. It would always reflect that initial 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.
Dynamic margin and the rise of the synthetic equity swap
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 Final Price, not the Initial Price, thereby dynamically adjusting margin on the fly, and without uncomfortable calls to the client to explain why.