What Is Variation Margin and How Does It Work?

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A key risk-management tool in the complex world of derivatives margin trading is variation margin. Variation margin is used to fully collateralize derivative contracts and ensure the stability of the market. But what exactly is variation margin and how is it calculated? 

This article will break down the ins and outs of this important concept and give you a better understanding of how it helps to mitigate risk and promote transparency in the derivatives market. From the variation margin formula to the initial and maintenance margin requirements, this article will give you a comprehensive overview of this critical aspect of derivatives margin trading.

6 Basics of Variation Margin

Variation margin is the amount of money that is required to be posted by one party of a derivatives contract to the other party to fully collateralize the contract. A variation margin is used to ensure that a clearing member’s margin account is sufficient to cover the risk of the futures contracts held by the clearing member. It is calculated as the difference between the current market value of the derivative contract and the initial or previous margin requirement.

The simple formula to compute variation margin is VM = Initial Margin – Margin Balance, where VM is the variation margin, initial margin is the initial margin requirement, and margin balance is the maintenance margin requirement.

To calculate variation margin, an investor must know the initial margin requirement, the maintenance margin requirement and the current price of the underlying security. The initial margin requirement is the amount of money an investor must have on hand to open a position in a given security, while the maintenance margin requirement is the minimum amount of money that must be maintained in the margin account to keep the position open.

The current price of the underlying security is used to determine how much the new initial margin requirement works out to be when the price of the underlying security drops. Once the initial margin requirement and the maintenance margin requirement are known, the investor can use the variation margin formula to calculate the difference between the two, which is the variation margin. 

Note that this is a simplified example, and the calculation can vary depending on the security and the market conditions.

Purpose of Variation Margin

The purpose of variation margin is to close the gap in margin requirement for a derivative contract and ensure that the counterparty is able to meet its obligations under the contract in case of a loss. It helps mitigate the risk for the parties involved in the contract and promotes market stability.

Used as Collateral

Variation margin is used as collateral for the successful execution of the derivative contract. In the event of a market downturn, the party that posted the variation margin is required to post additional collateral to the other party in order to fully cover the contract.

Clearing Members and Clearinghouses

Clearing members are firms that are members of a clearinghouse, which is a financial institution that acts as a middleman in the derivatives market. Clearinghouses are responsible for ensuring that the variation margin is properly posted and for managing the collateral.

Margin Call

A margin call is a demand for an increase in collateral, typically in the form of cash or securities, that is made by a clearinghouse or a counterparty when the value of the derivative contract falls below the required level. It’s a call for additional funds from an investor to meet the minimum margin requirement. 

A margin call is triggered when a margin account loses funds or opens up additional positions, dropping the investor’s equity below the required minimum for holding those positions. The broker sells the securities in the account if the investor fails to meet the margin call until the minimum requirement is met. 

Maintenance Margin Requirement

Maintenance margin requirement is the minimum level of collateral that must be maintained to keep a derivative contract open. It is an important factor in calculating variation margin, as it sets the threshold at which a margin call will be made.

Rules Regarding Variation Margin

The Financial Industry Regulatory Authority (FINRA) has mandated a variation margin rule that requires all firms that trade in derivatives to post variation margin to fully collateralize their contracts. This rule is designed to reduce counterparty risk and protect against market fluctuations.

Example of Variation Margin

Take a look at how a variation margin might work in practice:

An investor buys 100 shares of stock at $50 per share with an initial margin of 50%. This means the broker must have $2,500 in their account at all times. The maintenance margin is set at $1,250. If the stock price falls to $25, the broker deducts $2,500 in losses from the initial margin balance, leaving it at $0. The new initial margin requirement is now $1,250 ($25 per share x 50% x 100 shares), so the investor must make a variation margin payment of $1,250 to meet this requirement.

Initial Margin vs. Variation Margin

Initial margin and variation margin are both forms of collateral that are used in the derivatives market to reduce counterparty risk, but they serve different purposes.

Initial margin is the amount of collateral that is required to be posted by one party of a derivative contract to the other party at the time the contract is entered into. It is a fixed amount that is determined by the clearinghouse or counterparty and is based on the initial market value of the contract and the level of risk associated with the contract. The purpose of initial margin is to ensure that the contract is fully collateralized at the start of the contract.

Variation margin is the amount of collateral that is required to be posted by one party of a derivative contract to the other party in order to fully cover the contract at all times. It is calculated as the difference between the current market value of the derivative contract and the initial or previous margin requirement. The purpose of variation margin is to ensure that the contract remains fully collateralized as the market value of the underlying asset fluctuates.

Initial margin is fixed and posted only at the start of the contract, while variation margin is calculated and posted as the market value of the underlying asset fluctuates.

Variation Margin: Derivatives Market Safety Net

Variation margin is the protective mechanism that ensures contracts are fully covered at all times, regardless of market fluctuations. It is calculated as the difference between the current market value of the derivative contract and the initial or previous margin requirement. It is used to ensure that a clearing member’s margin account is sufficient to cover the risk of the futures contracts held by the clearing member. The variation margin ultimately helps mitigate the risk for the parties involved in the contract and promotes stability in the financial markets. 

Frequently Asked Questions

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The post What Is Variation Margin and How Does It Work? by Anna Yen appeared first on Benzinga. Visit Benzinga to get more great content like this.