Variation margin

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That kind of margin that isn’t initial margin.

A topic of some excitement in the dog days of January 2017, because financial counterparties and non-financial counterparties (at least where trading over the clearing thresholds are suddenly obliged to pay and collect it as a matter of regulatory necessity.

Variation margin is designed to remove the mark-to-market exposure to your counterparty under a derivative transaction. On any day where any party is entitled to call for it (in this day and age, that’s usually any business day), that party can calculate the present market value, or replacement cost of the transaction, and require the counterparty to deliver eligible collateral equal to that value (subject to thresholds and minimum transfer amounts).

This has the effect of re-setting the total exposure to (more or less) nil, and means that you can, for a brief moment, relax, safe in the knowledge that your shirt is safe. But volatile markets can quickly move — a day is a long time when black swans are migrating — so you might want something to tide you over for expected movements between now and when you can next call for margin. For that, you need initial margin.

There is an argument that variation margin creates more problems than it solves. But more or less the entire might of the global regulatory apparatus is stacked against that view, so take it in the contrarian view in which it is offered.

Initial margin and variation margin

Margin comes in two forms.

  • Variation margin, or VM, is collateral against the present mark-to-market value of the transaction exposure.
    • If you don’t have this and the counterparty goes bust, you’re whistling.
    • In many kinds of margin loan, VM will take the form of the asset in question itself.
  • Initial margin, or IM, is additional collateral in excess of the present mark-to-market value of the transaction exposure.
    • This guards against sudden adverse movements in the value of the collateral or the exposure between margin calls.
    • IM is calculated by reference to the expected maximum loss in value of the transaction (and the existing margin) over the margin period.

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