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Compare the margin requirements of bilateral markets with those of centrally cleared markets, and show how margin helps mitigate risk.

FRM® Part I · Financial Markets and Products · Central Clearing · FRM1.FM.6.e

The idea

Margin protects against the loss that follows a default. Variation margin is paid daily to reflect the change in mark-to-market value, so current exposure is reset to roughly zero. Initial margin covers the potential loss while the defaulter's portfolio is closed out, which is the margin period of risk. It is a high-confidence quantile of the change in portfolio value. IM = z × σ × V × √h. Here z is the confidence multiplier, σ the daily volatility, V the portfolio value and h the horizon in days. CCPs apply both margins to every member with no negotiated thresholds, using a shorter horizon, for example five days for cleared swaps. Bilateral margin is set by the credit support annex and was historically often one-way or subject to thresholds. Under the uncleared margin rules it uses a ten-day horizon with initial margin segregated. Exam point: horizon scaling is by the square root of time, not linear.

Formulas

Initial margin from volatility

IM = z × σ × V × √T

z
the standard normal quantile for the confidence level, 2.326 at 99%
σ
the daily volatility of the position's value, as a decimal
V
the value of the position
T
the margin period of risk in days

Volatility scales with the square root of time, not linearly. CCPs use a shorter horizon, such as five days for cleared swaps, than the ten days of the uncleared margin rules.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the main purpose of variation margin?

  1. To pass on the daily change in mark-to-market value of positions - correct
  2. To cover the potential loss during the time it takes to close out a defaulter's portfolioWhy not: Describes initial margin, which protects against potential future exposure, not variation margin.
  3. To fund the CCP's operating costs and capitalWhy not: Margin is collateral against default losses and is not a fee.
  4. To create a pool of resources shared among all clearing membersWhy not: Describes the default fund; variation margin is exchanged between each party and the CCP daily.

Variation margin passes mark-to-market gains and losses daily, removing current exposure. Initial margin is the buffer for what could happen between the last exchange and close-out.

A harder one

Which statement correctly contrasts margin in bilateral and centrally cleared markets?

  1. CCP margin is negotiated with each member individually, while bilateral margin is set by regulationWhy not: Reverses the two: the CCP sets uniform rules, and bilateral margin terms are negotiated in each credit support annex.
  2. Bilateral and cleared markets always use the same margin period and the same eligible collateralWhy not: Ignores differences; CCPs and bilateral agreements typically differ in horizons, eligible collateral and thresholds.
  3. Only cleared trades ever involve variation margin; bilateral trades never doWhy not: Bilateral trades also exchange variation margin under credit support annexes, and under the uncleared margin rules it is mandatory for covered entities.
  4. A CCP applies both margins to all members uniformly; bilateral margin is negotiated - correct

Central clearing imposes uniform margin on all members: both types, no negotiated thresholds, calculated by the CCP. Bilateral margin comes from negotiated annex terms (thresholds, minimum transfer amounts, eligible collateral), though the uncleared margin rules now narrow the differences.

The hardest tier

A CCP sets initial margin on a 5-day horizon at 99 percent, and a member's portfolio has a 1-day 99 percent loss of USD 3.0 million. Bilateral rules for the same portfolio require a 10-day horizon. Using square-root-of-time scaling, how much more initial margin is required bilaterally than at the CCP, in USD million, closest to?

  1. 2.78 - correct
  2. 6.71Why not: Takes the square root of the difference in days (sqrt(5)) in place of the difference of the square roots.
  3. 15.00Why not: Scales linearly: 3.0 x (10 - 5), instead of by the square root of time.
  4. 9.49Why not: Gives the 10-day margin itself, not the increase over the 5-day margin.

5-day IM = 3.0 x sqrt(5) = 6.71; 10-day IM = 3.0 x sqrt(10) = 9.49. The difference is 9.49 - 6.71 = 2.78. The bilateral margin is about 41 percent higher (the ratio is the square root of 2).

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