Margining is a form of Settlement, whereby exposure to Credit Risk between two parties is limited by keeping the overall Credit Exposure below a certain threshold by means of Margin payments between the parties whenever the threshold is breached
Detail
Let's take a simple example
I buy a delivery of 200 tonnes of coal from you at a fixed price of $60 per tonne, to be delivered in Antwerp in December 2018
Let's also assume the day we do the deal the forward price of coal for that delivery month and location (and quality) is also $60 per tonne (we agree on a daily published price to value the coal, in this case the Argus/McCloskey API 2 INDEX)
At the end of the first day the contract calls for me to pay you $12,000 at the time of delivery, and for you to deliver to me, what we both currently agree is, $12,000 with of coal at about the same time
We are even - we'll call this day one
If either of us goes out of business, or defaults in any way, then the other party will not lose out
Every day up until the delivery takes place we will recalculate the value of the coal and determine if one side would lose out if there were a default
At the end of day two we both note that the API 2 index is now set at $59 for November 2018 delivery
At this point I will still have to pay you the $12,000 cash, but you will only need to deliver to me $11,800 worth of coal
If you go out of business or default on the deal I won't lose out
But if I default then you will lose $200
I need to arrange for that $200 available to you in case I do default
we'll look at how that is arranged in a moment
On day three we both note that the price has risen to $62 per tonne - that's good for me, bad for you
Now if I default you won't need to deliver $12,400 worth of coal in exchange for $12,000 cash
But if you default then I'll be $400 worse off
You need to arrange for $400 to be available to me in case of default
Let's say on day eight the price rises to $66 per tonne
You now need to arrange for $1,200 to be available to me in case of default
We talked about making the cash available in case of default - how does that work?
in a clearing arrangement each if us has a margining account with a central clearing house
Before we even start trading we need to deposit some money into the account, and each time we execute a trade we need to make sure there is sufficient in the account to cover a certain amount of loss
Let's say we both deposit $1,500 initially and then an additional $1,000 as a result of doing the single trade - we can see that on typical price movement, for the volume of the trade this, then it would take quite a large movement in the price to change the value of the trade by $1,000
We both now have $2,500 deposited
The initial $1,000 deposit against this specific trade is called the Initial Margin
At the end of day two the clearing house would remove $200 from my account and put it into your account - this is the Daily Variation Margin
I now have $2,300 and you have $2,700
At the end of day three the clearing house would remove $600 from your account and put it into my account - this is the Variation Margin
That's $600 not $400 because it includes a refund of the $200 already taken out (the price swung by $3 per tonne - that's $600)
I now have $2,900 and you have $2,100
At the end of day eight I would have $3,700 and you have $1,300
At this stage you would need to make a payment into your account to top it back up to a minimum level - this may be $200, or it might be more depending on the agreement
Collateral
We might agree to post $2,000 collateral with each other to cover any initial movement either way
We agree to margin limits of a minimum of $1,500 and a maximum of $2,500, if the margin falls below $1,500 we will post a minimum of $500 to get the collateral back up to $1,500, and likewise, if the collateral goes above $2,500 we will be able to withdraw cash to bring it below $2,500
At the end of day two my collateral stands at $1,800 - the cash in the collateral account minus the $200 current liability on the deal at that point - we're both OK, I have more than the minimum $1,500
At the end of day three I have $2,400 collateral and you have $1,600 (your original $2,000 less your current liability of $400 on the deal)
At the end of day eight I have $3,200 collateral, and you have just $800 (your original $2,000 less your current liability of $1,200 on the deal)
you need to transfer $700 into your collateral account held by me, I can withdraw $700
A requirement to top up a clearing account or collateral account is known as a margin call
Participants