MARGIN SYSTEM

Margins

A potential problem of dealing in futures is that having made a profit, the other party ‘to the contract’
has therefore made a loss and defaults on paying you your profit. This is termed ‘counter party credit
risk’.

However the buyer and seller of a contract do not transact with each other directly but via members of
the market. Therefore the market's Clearing House is the formal counter party to every transaction. This
effectively reduces counter party default risk for those dealing in futures.

As the Clearing House is acting as guarantor for all deals it needs to protect itself against this enormous
potential credit risk. It does so by operating a margining system, i.e. an initial margin and the daily
variation margin.

The initial margin

When a futures position is opened the Clearing House requires that an initial margin be placed
on deposit in a margin account to act as a security against possible default.

The objective of the initial margin is to cover any possible losses made from the first day's
trading. The size of the initial margin depends on the future market, the level of volatility of the
interest rates and the risk of default.

Some investors use futures for speculation rather than hedging. The margin system allows for
highly leveraged ‘bets’.

Maintenance margin, margin call and the variation margin

When the hedge is set up, the Clearing House specifies an amount ('the maintenance margin')
which represents the minimum amount that the client must keep in the margin account.

At the end of each day the Clearing House calculates the daily profit or loss on the futures
position. This is known as ‘marking to market’. The daily profit or loss is added or subtracted to
the margin account balance.

Marking to market refers to the daily settling of gains and losses due to changes in the market value of
the security.

If this causes the amount in the margin account to fall below the specified maintenance margin,
a 'margin call' is made to the investor, requiring the investor to deposit extra funds (the
'variation margin') to top-up the margin account.
An inability to pay the variation margin causes default and the contract is closed, thus
protecting the Clearing House from the possibility that the investor might accumulate further
losses without providing cash to cover them.

SCENARIO 1

Exam: December 2018

Question: Nutourne Co

Marks: 6

Here the LC = US$ and FC = CHF

Currency futures contract size CHF125,000 = FC

No of future contracts = 98

The non-executive director has also heard about the mark-to-market process and wants to understand
the terminology involved, and how the process works, using the transaction with the Swiss customer as
an example.

The treasury department has supplied relevant information to answer his query.

CHF futures contract states that an initial margin of US$1,450 per contract will be required and a
maintenance margin of US$1,360 per contract will also be required.

The tick size on the contract is US$0·0001 and the tick value is US$12·50.

You can assume that on the first day when Nutourne Co holds the futures contracts, the loss per
contract is US$0·0011.

Requirement:

Explain to the non-executive director how the mark-to-market process would work for the CHF futures,
including the significance of the data supplied by the treasury department. Illustrate your explanation
with calculations showing what would happen on the first day, using the data supplied by the treasury
department. (6 marks)
SOLUTION

Initial Margin

The mark-to-market process begins with Nutourne Co having to deposit an amount (the initial margin) in
a margin account with the futures exchange when it takes out the futures. The margin account will
remain open as long as the futures are open. The profit or loss on the futures is calculated daily and the
margin account is adjusted for the profit or loss.

In the example, initial margin = $1,450 x 98 = $142,100

Maintenance Margin Account

The maintenance margin is the minimum balance which has to be maintained on the margin account.

Maintenance margin = $1,360 x 98 = $133,280

Variation Margin/Margin Call

If the losses on the futures are so large that the balance on the margin account is less than the
maintenance margin, then the futures exchange will make a demand (a margin call) for an extra
payment (the variation margin) to increase the balance on the account back to the maintenance margin.

Loss

You can assume that on the first day when holds the futures contracts, the loss per contract is
US$0·0011.

Total loss = 98 Contracts x US$ 0.0011 loss per contract = $13,475

Settlement

Initial Margin Account = $142,100

Balance on margin account = $142,100 – $13,475 = $128,625

This is less than the maintenance margin, so Nutourne Co would have to deposit an extra ($133,280 –
$128,625) = $4,655 (the variation margin) to bring the balance on the margin account up to the
maintenance margin.

Alternative solution

In some exchanges, a variation margin may be required to increase the balance on the account back to
its initial margin level (we can say, maintenance margin is equivalent to the initial margin)

Therefore, in this case, the variation margin amount would be $13,475 (i.e. $142,100 – $128,625).
SCENARIO 2

Exam: March 2020

Question: Boullain Co

Marks: 7 Marks

Assume today’s date is 1 March 20X0

Here the LC = € and FC = US$

Case about FC (€) receive. (Risk for FC reduce or LC increase)

September € Future Contract = US$/€ = 1.1422 (READING: PAY 1.1422 US$ FOR 1€)

Currency futures contract size €200,000

No of future contracts = 81

Margin information

Once the position is open, the euro futures contract outlined above will be marked-to-market on a daily
basis. The terms of the contract require Boullain Co to deposit an initial margin of $3,500 per contract
with the clearing house.

Assume the maintenance margin is equivalent to the initial margin. LOSS = MAINTENANCE MARGIN

The tick size on the contract is $0·0001.

Your manager is concerned about the impact of an open futures position on cash flow and has asked
you to calculate and explain the impact of the following hypothetical changes in the closing settlement
price in the first three days of the contract.

Closing settlement prices (US$ per €1)

Date Settlement price

1 March 1·1410

2 March 1·1418

3 March 1·1433

Calculate and explain the impact of the open futures position on Boullain Co’s US$ cash flow, based on
the settlement prices provided. (7 marks)
SOLUTION

Initial margin = maintenance margin = $3,500 x 81 = $283,500

1 March:

US$/€

((1·1410 – 1·1422) x $200,000 x 81 = $19,440 loss

Maintenance margin is 100% of initial margin:

Therefore variation margin = $19,440

2 March:

(1·1418 – 1·1410) x $200,000x 81 = $12,960 profit.

3 March:

(1·1433 – 1·1418) x $200,000 x 81 = $24,300 profit.

In order to reduce counter-party risk, Boullain Co deposits the initial margin of $283,500 with the
clearing house when the futures position is opened. The notional profit or loss at each day’s closing
settlement price is added to or subtracted from the margin account balance. If the margin account
balance falls below the level of the maintenance margin, Boullain Co is required to deposit additional
funds to top up the margin account.

Boullain Co makes a notional loss at the end of the first day and would therefore pay a variation margin
to return the margin account to the level of the specified maintenance margin.

Since Boullain Co makes a notional profit on the subsequent two days, the amount in the margin
account will be greater than the specified maintenance margin and no variation margin is required. The
profit on each of those days may be withdrawn in cash.
SCENARIO 3

Exam: June 2015

Question: Daikon Co

Marks: 10 Marks

Assume today’s date is 1 June 2015

Case about Interest Rate Lending. (Risk for IR reduce or BV increase)

December Future Contract = 95.84

Futures contract size $2500

No of future contracts = 50 (Mention with question)

Details

In the talk, the CEO was informed of the following issues:

Issue 1

Futures contracts will be marked-to-market daily.

The CEO wondered what the impact of this would be if 50 futures contracts were bought at 95·84 on 1
June and 30 futures contracts were sold at 95·61 on 3 June, based on the $ December futures contract
given above. The closing settlement prices are given below for four days:

Date Settlement price INTEREST RATE

1 June 95·84

2 June 95·76

3 June 95·66

4 June 95·74

Issue 2

Daikon Co will need to deposit funds into a margin account with a broker for each contract they have
opened, and this margin will need to be adjusted when the contracts are marked-to-market daily

Issue 3

It is unlikely that option contracts will be exercised at the end of the hedge period unless they have
reached expiry. Instead, they more likely to be sold and the positions closed.

Requirement:

Discuss the impact on Daikon Co of each of the three further issues given above. As part of the
discussion, include the calculations of the daily impact of the mark-to-market closing prices on the
transactions specified by the CEO. (10 marks)
SOLUTION

Issue 1

2nd June:

Total 50 Contracts:

1st June: 95.84 = 4.16%

2nd June: 95.76 = 4.24%

Loss on futures = 8 Basis Points

Total loss = 50 Contracts X 0.08 X $2500/Contract = 10,000

3rd June:

30 Contracts Sold:

2nd June: 95.76 = 4.24%

3rd June: 95·61 = 4.39% (Sale value of Future Contract)

Loss on futures = 15 Basis Points

Total loss = 30 Contracts X 0.15 X $2500/Contract = 11,250

Remaining 20 Contracts:

2nd June: 95.76 = 4.24%

3rd June: 95·66 = 4.34%

Loss on futures = 10 Basis Points

Total loss = 20 Contracts X 0.10 X $2500/Contract = 5,000

4th June: (Remaining 20 contracts)

Remaining 20 Contracts:

8 basis points (95·74 – 95·66) x $25 x 20 contracts = $4,000 profit

3rd June: 95·66 = 4.34%

4th June: 95.74 = 4.26%

Gain on futures = 8 Basis Points

Total loss = 20 Contracts X 0.08 X $2500/Contract = 4,000

Margin Account

Both mark-to-market and margins are used by markets to reduce (eliminate) the risk of non-payment by
purchasers of the derivative products if prices move against them.

Mark-to-market closes all the open deals at the end of each day at that day’s settlement price, and
opens them again at the start of the following day. The notional profit or loss on the deals is then
calculated and the margin account is adjusted accordingly on a daily basis.

The impact on Daikon Co is that if losses are made, then the company may have to deposit extra funds
with its broker if the margin account falls below the maintenance margin level. This may affect the
company’s ability to plan adequately and ensure it has enough funds for other activities. On the other
hand, extra cash accruing from the notional profits can be withdrawn from the broker account if
needed.

Each time a market-traded derivative product is opened, the purchaser needs to deposit a margin (initial
margin) with the broker, which consists of funds to be kept with the broker while the position is open.
As stated above, this amount may change daily and would affect Daikon Co’s ability to plan for its cash
requirements, but also open positions require that funds are tied up to support these positions and
cannot be used for other purposes by the company.

Issue 3

Option Contracts – Tradable

The value of an option prior to expiry consists of time value, and may also consist of intrinsic value if the
option is in-the-money. If an option is exercised prior to expiry, Daikon Co will only receive the intrinsic
value attached to the option but not the time value. If the option is sold instead, whether it is in-the-
money or out-of-money, Daikon Co will receive a higher value for it due to the time value. Unless
options have other features, like dividends, attached to them, which are not reflected in the option
value, they would not normally be exercised prior to expiry