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MARGINING

Karthik Reddy. PInstitute of Public Enterprise

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FLOWOFPRESENTATION

Introduction - Margin

Types of margins.

VaR margin

Extreme loss margin Mark to market margin

Margins in futures and options segment

Margin call

Conclusion

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INTRODUCTION

In stock markets there is always an uncertainty in the

movement of share prices.

This uncertainty leading to risk is sought to be addressed

by margining systems by stock markets.

Suppose an investor, purchases 1000 shares of xyz

company at Rs.100/- on January 1, 2008. Investor has to

give the purchase amount of Rs.1,00,000/- (1000 x 100) to

his broker on or before January 2, 2008. Broker, in turn, has

to give this money to stock exchange on January 3, 2008.

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Investor pays a portion of total amount to the broker at thetime of placing the order. This initial token is calledmargin.

In the above example, assume that margin was 15%. That isinvestor has to give Rs.15,000/-(15% of Rs.1,00,000/) to thebroker before buying. Now suppose that investor bought theshares at 11 am on January 1, 2008. Assume that by the end

of the day price of the share falls by Rs.25/-. That is totalvalue of the shares has come down to Rs.75,000/-. That isbuyer has suffered a notional loss of Rs.25,000/-. In ourexample buyer has paid Rs.15,000/- as margin but thenotional loss, because of fall in price, is Rs.25,000/-. That is

notional loss is more than the margin given.

Margin payments ensure that each investor is serious aboutbuying or selling shares.

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MARGIN - TYPES

SEBI has prescribed different way to margin cash and

derivatives trades taking into consideration unique features

of instruments

Margins in the cash market comprises of the following:

Value at risk (VaR) margin

Extreme loss margin Mark to market margin

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VaR is a technique used to estimate the probability of loss of

value of an asset or group of assets based on statistical price

trends.

A VaR statistic has three components, a time period, a

confidence interval and a loss amount.

For example, consider shares of a company bought by an

investor. Its market value today is Rs.50 lakhs but its market

value tomorrow is obviously not known. An investor holdingthese shares may, based on VaR methodology, say that 1-day

VaR is Rs.4 lakhs at 99% confidence level.

This implies that under normal trading conditions the

investor can, with 99% confidence, say that the value of theshares would not go down by more than Rs.4 lakhs within

next 1-day.

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Extreme loss margin aims at covering the losses that could

occur outside the coverage of VaR margins.

The Extreme loss margin for any stock is higher of 1.5 timesthe standard deviation of daily LN returns of the stock price

in the last six months or 5% of the value of the position.

If in the Example the VaR margin rate for shares of ABC Ltd.was 13%. Suppose the 1.5 times standard deviation of daily

LN returns is 3.1%. Then 5% (which is higher than 3.1%)

will be taken as the Extreme Loss margin rate.

Therefore, the total margin on the security would be 18%(13% VaR Margin + 5% Extreme Loss Margin). As such,

total margin payable (VaR margin + extreme loss margin) on

a trade of Rs.10 lakhs would be 1,80,000/-.

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Mark to market is calculated at the end of the day on all

open positions by comparing transaction price with the

closing price of the share for the day.

In the above example, we have seen that a buyer purchased

1000 shares @ Rs.100/- at 11 am on January 1, 2008. If

close price of the shares on that day happens to be Rs.75/-,then the buyer faces a notional loss of Rs.25,000/ - on his

buy position. In technical terms this loss is called as MTM

loss.

MTM Profit/Loss = [(Total Buy Qty X Close price) - Total BuyValue] - [Total Sale Value - (Total Sale Qty X Close price)]

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MARGINSINFUTURESANDOPTIONSSEGMENT

In order to cover default risks, future exchanges prescribe

the margins to be kept by both parties in a contract.

Therefore, every trader should deposit some amount before

the execution of transaction. This amount is called as initial

margin or initial performance bond.

The initial margin is a certain percentage of a futures

contract value.

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The balance in the margin account should never be negative.

In order to ensure that, another kind of margin, known as

maintenance margin or maintenance performance bond isprescribed.

Whenever, the balance in the margin account falls below the

maintenance margin, the investor would receive a margincall, also known as Performance bond call

Then, the additional funds are deposited to bring the account

back up to initial margin. This is known as Variation

margin.

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MARGIN CALL

Margin call can be better understood from the following

example.

Assume, the initial margin on a futures contract is INR

10,000 and the maintenance margin is INR 7,500.

In the process of marking to market, the value of the

margin account of the investor has dropped to INR 4,000.

Then, the investor receives a margin call. so, the investor

has to deposit at least an additional INR 6,000 to bring theaccount back up to initial margin level of INR 10,000. this

additional fund (6,000) is variation margin.

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The trading transactions on a futures exchange are done

through the members of the exchange clearing house.

The members of clearing house are required to maintain

margin accounts with the clearing house. Such margins are

known as clearing margins.

The minimum levels for initial and maintenance margins

are fixed by future exchanges.

CME uses a computerized risk management program called

SPAN to decide on margin requirements.

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Margin requirements vary based on the type of traders,

hedgers or speculators.

Securities like treasury bills are also accepted as initial

margin, but the maintenance margins are generally in cash

only.

The SPAN margins are revised six times a dayonce at the

beginning of the day, 4 times during market hours and once at

the end of the day.

In addition to the initial margin, a Premium margin is charged

to trading members trading in options contracts.

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The premium margin is paid by the buyers and is equal to

the values of the options premium multiplied by the quantity

of options purchased.

For example, if 1000 call options on ABC Ltd are purchased

at Rs. 20/-, and the investor has no other positions, then the

premium margin is Rs. 20,000.

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CONCLUSION

The whole purpose of the margining system is to reduce

the possibility of market participants sustaining lossesbecause of defaults.

Losses arising from defaults in contracts at major

exchanges have been almost non existent

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Thank you