Variation margin

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A word about credit risk mitigation

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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, or “VM”, is a credit mitigation technique designed to minimise the credit risk parties have to each other under bilateral derivative transactions. It requires the counterparties give each other collateral — typically cash — each day to ensure that their net collateralised exposure is effectively nil. For example, if the net “replacement cost” of the swaps between two counterparties on a given day is $10 million, the “out-of-the-money” party, who would have to pay it were all the transactions terminated, has to pay the “in-the-money” counterparty $10 million in cash (subject to agreed Thresholds and Minimum Transfer Amounts). This happens every day; variation margin can be paid either way, depending on how the net portfolio moves. Volatile markets can quickly move — a day is a long time when black swans are on the wing — so parties often want a little something extra to tide them over for expected movements between now and the next variation margin payment date. For that, you need initial margin.

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.

The JC is a contrarian you see, and he thinks requiring brokers to pay their clients variation margin is an utterly stupid idea. There is a ten billion dollar hole in the ground he calls “evidence”.

See also