The variation margin is an additional fund required to be deposited to the future’s trading account to ensure the availability of sufficient margin when a future contract is subject to losses. To understand variation margin following terms need to be understood.
The initial margin is the amount required to be submitted in the trading account when entering the future contract. Both sellers and the buyers need to submit this amount to the trading account.
This amount/initial margin acts as collateral for the overall future contract. The initial margin can be set as a percentage of the future’s price or some absolute amount.
Maintenance margin is the minimum amount of the funds that must be maintained in the trading account by each of the parties in the contract. Both parties need to keep the maintenance margin in their trading account, or the contract can be liquidated.
Explanation of the concept
Consider two parties enter into a contract to sell and purchase the future contract. The futures contract is to sell and purchase the 50 kg of Apple precisely after six months for a pre-agreed price of USD 500. The initial margin for this future contract is USD 50, and the maintenance margin is USD 30.
After two weeks, there is news in the market that a future contract for the 50kg of Apple is trading at USD 485. It means the market is volatile, adversely affecting the buyer of the contract.
So, to ensure a smooth run of the futures contract, the broker deducts USD 15 (USD 500-USD 485) from the trading account of the future’s buyer to reflect the current market position. So, the remaining balance in the buyer’s trading account is USD 35 (USD 50 – USD 15).
However, USD 35 is still higher than the maintenance margin of USD 30. Suppose there is again the movement of the future’s price and falls by USD 10. So, now the balance in the trading account will be USD 25 (USD 35- USD), which is less than the maintenance margin.
So, the broker can call the buyer of the future and request to add the USD 25 to reach the threshold of USD 50. This added amount of USD 25 is called marginal variation.
The margin call is when the trader’s broker notifies that there is a need to deposit money in the trading account. The margin call is made when the funds in the trading account fall below the maintenance level.
The funds requested in the margin call bring the trading balance equal to the initial margin amount.
Difference between initial margin and variation margin
The initial margin is the amount of funds to be deposited for entering the future contract. The amount can be set as a percentage of the agreed price for the futures contract or even in absolute numbers.
On the contrary, the variation margin is the amount required to top-up the trading account to the minimum margin level.
How to calculate variation margin
The variation margin is only payable at the time when the balance of the trading account reached below the maintenance margin. Usually, there is a level of safety between the initial margin and the maintenance margin.
If the balance remains between the initial margin and maintenance margin, there is no obligation to pay any margin. However, once the balance reached below the maintenance margin the trader has to top to the threshold of the initial margin.
So, the formula for the calculations of variation margin is given as under.
The margin balance is the amount in the trading account which must be below maintenance level. It is important to note that a margin call is only made when the margin balance reaches below the maintenance margin or the derivative.
Purpose of variation margin
Variation margin helps the derivative market in multiple ways. Some of these are given below.
- Variation margin ensures mark to market of the futures contract daily. Hence, any losses in futures contracts are covered immediately.
- It’s a great way to protect the interest of the parties in the future contract. If one of the parties defaults for the futures contract, it helps to compensate the other party.
- The funds obtained via variation margin helps to clear houses to maintain the risk of the contracts. Further, it also helps in liquidity for making orderly payments to the traders.
- It helps traders to manage the risk exposure.
Since the clearinghouse/exchange acts as guarantor for the successful execution of the forward contract. Receiving funds under variation margin is a more excellent help for them, or they could go bankrupt as the default risk would have been much higher without any variation margin/collateral.
Variation margin as collateral
The variation margin acts as collateral for the successful execution of the derivative contract. It helps to protect the interest of the party gaining the benefit of entering into the contract. The balance in the trading account is assessed daily after accounting for the market fluctuations.
In other words, the contract is marked to market daily to get the current value and assessment of the trading account balance if it has reached the threshold, and a margin call needs to be made.
Overall, variation margin gives specific protection to the traders and the clearinghouses as well. It acts as collateral as the party at a loss may not want to pay the loss.
To understand the variation margin, there is a need to understand the terms that include initial margin, maintenance margin, mark to market, and margin balance, etc.
The initial margin is the amount agreed by the traders while entering into the futures contract. The maintenance margin is the threshold balance.
Once the balance in the trading account is below the threshold, the broker makes a call for the top-up to the extent of the initial margin. Hence, the amount required to convert the margin balance equivalent to the initial margin is the variation margin.