A word about credit risk mitigation
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.
Margin comes in two forms.
- Variation margin, or VM, is collateral against the present mark-to-market value of the transaction exposure.
- 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”.