Account for the margin rules that apply to centrally-cleared derivatives and to those not centrally cleared.
The idea
Margin rules differ by clearing status. For centrally cleared derivatives the CCP sets its own rules. Initial margin is sized to cover close-out losses over a period typically around five days for OTC products, variation margin is paid daily, and clearing members contribute to a default fund. For derivatives not centrally cleared, the BCBS-IOSCO framework requires covered entities to exchange variation margin and initial margin in both directions. Bilateral initial margin is based on a 99 percent one-tailed loss over ten days. It is collected gross rather than netted between the parties, is segregated from the collecting party's own assets and generally not reused, and is sized without diversification benefits across asset classes. Variation margin is exchanged at least daily. The usual mistake is to treat initial and variation margin as interchangeable. Exam point: initial margin covers future moves, variation margin covers moves already made.
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
Bilateral margin for non-cleared trades uses 99% over ten days; CCPs typically use about five days for OTC products. Volatility scales with √T, not T.
A practice question
Which margin payments apply to centrally cleared OTC derivatives?
- Variation margin only, because initial margin applies solely to non-cleared tradesWhy not: Wrongly drops initial margin, which is a core CCP requirement.
- Initial margin only, with variation margin replaced by an end-of-trade settlementWhy not: Wrongly drops daily variation margin, which resets mark-to-market each day.
- Default fund contributions only, since margin is not required once a CCP is involvedWhy not: Wrongly treats the default fund as a substitute for margin; it is an additional resource.
- Initial margin and variation margin, plus clearing members' default fund contributions - correct
Cleared trades involve initial margin for potential future moves, variation margin for moves already made, and a mutualised default fund funded by clearing members.
A harder one
Where is initial margin held under the bilateral margin rules for non-cleared derivatives?
- With the counterparty outright, which may use it freely as part of its own fundingWhy not: Describes title transfer to the collecting party, which the segregation requirement is designed to prevent.
- In a default fund shared by all dealers that clear the same productsWhy not: Describes a CCP default fund, a feature of clearing and not of bilateral margin.
- With a third-party custodian, segregated and not re-used - correct
- Netted against variation margin so that only a single net amount is exchangedWhy not: Initial and variation margin are separate and not netted against each other.
Bilateral initial margin is segregated with a custodian and not rehypothecated, so that the posting party is protected if the collecting party fails.
The hardest tier
Under bilateral margin rules, a dealer calculates the following standalone initial margin on its client's trades: interest rates USD 40 million and equities USD 30 million. Diversification benefits across asset classes are not recognised. The initial margin required is:
- USD 50 millionWhy not: Assumes zero correlation: sqrt(40² + 30²). Cross-asset diversification is not recognised.
- USD 10 millionWhy not: Nets the two amounts as if the portfolios offset each other, which is not permitted across asset classes.
- USD 40 millionWhy not: Takes the larger of the two amounts rather than adding them.
- USD 70 million - correct
Offsets are recognised only within an asset class, so the requirement is the sum 40 + 30 = 70 million.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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