Methodologies of Margin Setting for Exchanges

Rabinder K. KoulManaging Director and Head of Risk ServicesGateway Partners

There are two concerns when setting margin requirements:

The margins should not be too low so that the exchanges and clearinghouses realize losses.

The margins should not be too high as it will hinder business.

The methodology used for calculating margin requirements depends largely on the following factors:

Product type

The rules of the exchange on which the product is listed and/or the primary regulator of the carrying broker

There are several different methodologies used for setting up margin requirements. However, these can be broadly classified under two categories:

Risk-based methodologies

Rule-based methodologies

Risk-based methodologies seek to apply margin coverage reflective of the change in the value of products in respect to changes in market, credit, and liquidity conditions. The non-linear risk of derivative products is measured using mathematical pricing models, such as when modeling options on the underlying futures. These models, while intuitive, involve computations which may not be easily replicated by the client. Since their inputs rely upon observed market behavior, its risk estimates fluctuate with the change in market conditions. Thus, risk-based methodologies require two types of models.

Pricing Models: The pricing models are product specific and product structure specific. Therefore, it is not possible to cover all derivative products by a single model. Additionally, pricing models are a prerequisite for many of the risk models to work properly. This is especially true for derivative and structured products.

For options, the most commonly used models are:

Black-Scholes

Black-76

Binomial Models

Additional types that can handle spreads, etc.

Classifications of risk models:VaR (Value at Risk) Models

Historical data based VaR models

Monte Carlo simulation based VaR models

Stress VaR Models

Historical method

Monte Carlo method

Stress Models

Historical stress models

Event based stress models

Scenario based models.

VaR (Value at Risk) ModelsThese models can measure the portfolio based risk exposure along with sub-portfolio based risk exposure at the product level as well as the counterparty level. The main parameters that one needs to fix is the confidence level, the time horizon over which risk is to be measured, the number of historical days as source of data, and the correlation data.

VaR models have the advantage of taking into account the correlations between different products which can actually reduce the margin requirements.

Stress VaR Models

These work in a similar fashion to VaR models but are based on a shorter data window, usually one year.

Stress Models

Stress scenarios based risk exposure calculation and loss is considered more desirable to capture extreme cases of market stress. Stress models have the disadvantage of not incorporating correlation among different products.

For each product there are several different types of margin charges that are normally considered for margin reserve:

Mark-to-Market Margin / Variation Margin - the price at which an open position can be instantaneously liquidated

Liquidation Risk Margin / Initial Margin - the margin required to cover the cost of adverse changes in the market while liquidating commodities

Accounts Receivable Margin - primarily used for physical commodities already delivered that generates the net amount owed to the exchange

Mark-to-market margin is the price at which an open position can be instantaneously liquidated. It has two components. In our case, the main role is marking to market of a position. In the case of options, this is carried out by the appropriate valuation model.

Mark-to-Market of Offsetting Positions - a portfolio contains long and short positions which are transacted at different prices. The profit and loss of these offsetting positions is the first component of variation margin.

Open Variation Margin - this constitutes the difference between the current mark-to-market of the net position and the initial purchase price

Net Mark-to-Market Margin = MMKT of offsetting position + MMKT of net position

Liquidation risk margin / initial margin is the margin required to cover the cost of adverse changes in the market while liquidating commodities. To measure this premium, one must obtain a risk premium associated with different products.

Initial Margin Rate or Liquidation Margin = Margin Premium x Size of the Portfolio x Duration

The duration is decided by the liquidation period one can assume in adverse liquidity conditions.

Initial margin is set by the use of risk models in consideration of the maximum loss.

Accounts receivable margin is primarily used for physical commodities that have already been delivered and generates the net amount owed to the exchange. Its calculation depends upon the length of the contract, its delivery details, and the contract settlement date.

Physical Natural Gas Accounts Receivable

Physical natural gas contracts are settled on the 25th day of the next month while the start day of the contract is first of the month.

Accounts Receivable Margin = (Purchase Quantity - Sales Quantity) x Weighted Average Price x Duration (# of Days)

Accounts receivable margin is primarily used for physical commodities that have already been delivered and generates the net amount owed to the exchange. Its calculation depends upon the peculiarities of the length of the contract, its delivery details, and the contract settlement date.

Financial monthly accounts receivable

Financial contracts are settled against a monthly index and settled in the same month for which it is traded. The accounts receivable begins the first of the calendar month and continues to the settlement day of the month on a fixed business day.

Total Margin = MMKT Margin + Liquidity Margin + Accounts Receivable Margin

The following methodologies are used in the market:Standard Portfolio Analysis of Risk

Theoretical Intermarket Margin System

Window Method

All three methodologies use some of the above risk-based methodologies.

Standard Portfolio Analysis of Risk

Main methodology used is stress analysis along with valuation models for individual products

Theoretical Intermarket Margin System

OMS Method

All three methods use some of the above risk-based methodologies.

SPAN is a Chicago Mercantile Exchange product that is widely used by many exchanges. It primarily uses VaR and stress analysis incorporating sixteen different scenarios.

SPAN is used for calculating margins for futures and options. Hence, its primary risk factors are price change or price of the underlying index change and the implied volatility of the option.

These sixteen scenarios are based on changes in prices as well as changes in volatility.

Each contract is revalued under all sixteen scenarios.

Using these valuations of each contract, one can compute the loss of each contract for all sixteen scenarios.

SPAN Methodology (Continued)

Using the array of contracts in the sub-portfolio of each product we can compute the losses of each sub-portfolio of similar products.

The maximum loss out of the sixteen scenarios is taken as the margin for the sub-portfolio of that contract.

This loss is called the Scanning Risk Margin.

Notice that all contracts go through the same set of 16 scenarios, not accounting for inter-month spreads, and one assumes perfect correlations between the delivery months. To correct for these deficiencies, the following corrections are implemented:

SPAN Methodology (Continued)

To obtain the total margin, adjustments are made for the inter-month margin, inter-commodity margin concessions, and spot month isolations.

The net options value is used only for premium style options, namely current market value of the option positions.

Option deltas are used to find equivalent futures positions for incorporating option margins.

Total Initial Margin = SPAN Risk Margin + Inter-Month Risk Margin – Inter-Commodity Spread – Net Option Value.

SPAN Risk = Max (Risk Margin + Inter-Month Margin – Commodity Spread Margin, Short Option Minimum Margin) + Net Option Value.

Standard OMS Method

This method also uses stress scenario methodology. Standard OMS Method uses approximately 93 different scenarios.

Rule Based Methodologies

These methods generally assume uniform margin rates across all products.

These methods do not provide any inter-product offsets.

Consider the derivative products similar to their underlying products.

In this sense, the method offers easy computation of the margin requirements.

However, even though it provides ease of application, it may overstate or understate the actual risk undertaken.

The central bank, the Federal Reserve Board, holds responsibility for maintaining the stability of the financial system. It does this, in part, by governing the amount of credit that broker-dealers may extend to customers who borrow money to buy securities on margin. This is accomplished through Regulation T (Reg T). Similarly, FINRA also provides certain guidelines for margin calculations.

Reg T

It only establishes the initial margin requirements, maintenance margin, and payment rules on certain securities transactions.

Reg T currently requires an initial margin deposit equal to 50% of the purchase value, allowing the broker to extend credit or finance the remaining 50%.

Reg T (Continued)

The amount necessary to continue holding a position once initiated is set by exchange rule (25% for stocks).

Reg T also does not establish margin requirements for securities options as this falls under the jurisdiction of the listing exchange’s rules which are subject to SEC approval. Options held in a Reg T account are also subject to a rules based methodology where short positions are treated as stock equivalents and margin relief is provided for spread transactions.

There are also requirements for starting a margin account.

Reg T (Continued)

Margin Requirements on Leveraged ETF’s:

Long an ETF having a 200% leverage factor: 50% (2 x 25%)

Short an ETF having a 300% leverage factor: 90% (3 x 30%)

ETF Index Option: Reg T maintenance margin requirement for a non-leveraged, short, broad based ETF index option is 100% of the option premium plus 15% of the ETF market value, less any out-of-the-money amount (to a minimum of 10% of ETF market value in the case of calls and 10% of the option strike price in the case of puts). In cases where the option underlying is a leveraged ETF, however, the 15% rate is increased by the leverage factor of the ETF.

The Financial Industry Regulatory Authority (FINRA) provides requirements to be an eligible participant. These rules cover the eligibility rules for participating in uncovered short options.

Portfolio margin requirements must be in compliance with FINRA option rules. These are not applicable to non-option positions.

Currently, the maintenance margin requirement for a listed, uncovered option for an ETF on a broad-based index or benchmark is:

100% of the option premium

Plus 15% of the ETF market value

Less any out-of-the-money amount

Subject to a minimum requirement of:

100% of the option premium plus 10% of the ETF market value for call options

And 100% of the option premium plus 10% of the exercise amount for put options.