Definition
Variation Margin refers to the additional funds that must be deposited by a futures contract participant when their margin account falls below the maintenance margin level due to market fluctuations. Essentially, it is the payment made to cover the day-to-day losses that come from trading activities. The requirement of a variation margin aims to ensure the creditworthiness of the issuer and reduce the level of credit risk in futures trading.
Phonetic
The phonetics of the keyword “Variation Margin” would be /ˌveəriˈeɪʃən ˈmɑːrdʒɪn/
Key Takeaways
- Variation Margin Represents Ongoing Cost: Variation margin represents the ongoing cost or profit of a financial derivative. It’s the additional funds that clearing houses and brokers require from investors to cover potential shortfalls.
- Fluctuations Result in Variation Margin Payments: When market prices fluctuate, variation margin is calculated and either paid or received. The ongoing payment or receipt of variation margins ensures that the total value of the contract remains consistent.
- Crucial in Risk Management: Variation margin is a critical component in the futures market as it indicates the level of risk exposure. It helps ensure that potential credit risk can be covered, thus providing a form of protection for both trading parties.
Importance
Variation Margin is an essential concept in business/finance because it reduces credit risk in financial transactions. Acts as a safeguard mechanism in futures and options trading, the variation margin is the extra funds traders are obliged to pay to their brokers following a loss on an open position. This concept compels every trader or investor to maintain a specific level of equity in their brokerage account, ensuring that the investor can cover potential losses. By continually balancing the account in response to changes in market value, the variation margin minimizes the probability of default, consequently increasing the efficiency and stability of financial markets overall.
Explanation
The purpose of Variation Margin in the financial world is primarily to protect both parties involved in a derivatives contract (such as futures or options). It acts as a type of insurance against a potential default risk, as its function is to anticipate and cover any possible change between the value of the derivative and the amount accumulated in the margin account at a given time. Variation margin is therefore a form of collateral that the party who is at potential loss calls for in order to protect their position.
Used for ensuring smooth operations in the futures and options market, the variation margin plays a crucial role in upholding the credibility of the market by maintaining a required level of sufficiency in the margin account. As the price of the underlying asset fluctuates, variation margin helps to ensure that the overall credit risk doesn’t exceed certain limits. This practice ultimately helps foster a stable, secure, and reliable market environment by mitigating risk, thus providing assurance to both parties involved in the derivatives contract.
Examples
1. Trading in Future Contracts: In the world of futures trading, variation margin plays a crucial role. For instance, if a trader enters into a futures contract to buy 1000 barrels of oil at $50 per barrel, they’ve effectively agreed to spend $50,000. However, prices fluctuate daily. If the price shoots up to $60 per barrel the next day, the buyer would have a $10,000 liability, forming the variation margin that needs to be settled to the futures exchange right away. So, the variation margin helps limit the potential loss associated with price changes in futures trading.
2. Forex Trading: Variation margin is also common in forex trading. Consider the scenario when a U.S. company decides to enter in a forex swap transaction to purchase British Pounds for a future date at a predetermined exchange rate. If the exchange rate begins to move unfavorably, the U.S. company would be required to post a variation margin to cover the loss in value of the contract. This provides security to the counterparty and reduces risk.
3. Derivatives Trading: Banks and financial institutions often use Interest Rate Swaps (IRS) or Credit Default Swaps(CDS) to hedge against interest rate or credit risk. If the value of these swaps moves against the party at the end of the day, they have to post a variation margin to mark the contract to market. For instance, if a bank used an IRS to offset potential losses from a rise in interest rates and instead the rates fall, the bank would need to post a variation margin to cover the effective loss.
Frequently Asked Questions(FAQ)
What is Variation Margin in finance?
Variation Margin refers to the additional funds a broker may request from an investor to cover potential losses due to changes in the market value of securities held in an investment account.
Why is Variation Margin important for margin accounts?
Variation Margin is crucial for maintaining the balance in margin accounts. If the market goes against an investor’s position, the Variation Margin helps cover the potential losses and secures the broker’s investments.
How is the Variation Margin determined?
Variation Margin is determined by the difference between the initial margin or the amount deposited to open a trading position, and the maintenance margin or the lowest amount that must be maintained in a trading account.
Who requests the Variation Margin?
Variation Margin is typically requested by the broker or the clearinghouse involved in the transaction.
How often is Variation Margin calculated?
Variation margin is usually calculated daily (or more often if the market is highly volatile), accounting for the current market prices of the given security.
Does Variation Margin involve physical cash?
Yes, Variation Margin requests typically require the investor to deposit additional physical cash or highly liquid securities into their margin account.
How does Variation Margin impact investors?
Variation Margin impacts investors by putting them at risk of a margin call (a demand by a broker for an investor to deposit additional money). If the investor fails to meet this demand, the broker might liquidate their assets to cover the margin.
Is Variation Margin applicable in derivative markets only?
While Variation Margin is particularly significant in derivative markets like futures and options, it also applies to leveraged positions in other markets where borrowed capital is used.
What happens if I can’t pay the Variation Margin?
If you are unable to pay the Variation Margin, your broker has the right to close your positions to cover the losses. In some cases, this could result in financial loss if your assets are sold at a lower price than what you paid.
What’s the difference between initial margin and variation margin?
The initial margin is the minimum collateral required to open a position, while the variation margin is additional collateral required when the market moves against the position, causing a potential loss.
Related Finance Terms
- Mark-to-Market: This is a process of valuation adjustment of securities to reflect their market value.
- Initial Margin: This is the minimum amount that traders are required to deposit into their accounts as collateral to hold a position.
- Collateral Management: It’s a process of mitigating credit risk in unsecured financial transactions by posting collateral.
- Clearing House: This is a financial institution formed to facilitate the exchange of payments, securities, and derivatives transactions.
- Margin Call: A demand by a broker that an investor deposit further cash or securities to cover possible losses.
