What is Margin Money?

The aim of margin money is to minimize the risk of default by either counter-party. The payment of margin ensures that the risk is limited to the previous day's price movement on each outstanding position. However, even this exposure is offset by the initial margin holdings. Margin money is like a security deposit or insurance against a possible future loss of value.

There are different types of margin viz. Initial Margin, Variation margin (or Mark-to-Market Margin ) and Additional margin.-

• Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected. The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction. This margin is calculated by SPAN (Standard Portfolio Analysis of Risk) by considering the worst case scenario.

• Mark to Market Margin (MTM)- collected in cash for all futures contracts and adjusted against the available liquid networth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement. All daily losses must be met by depositing of further collateral - known as variation margin, which is required by the close of business, the following day. Any profits on the contract are credited to the client's variation margin account.

Some exchanges work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the maintenance margin limit. For e.g.. If Initial Margin is fixed at 100 and Maintenance margin is at 80, then the broker is permitted to trade till such time that the balance in this initial margin account is 80 or more. If it drops below 80, say it drops to 70, then a margin of 30 (and not 10) is to be paid to replenish the levels of initial margin. This concept is not being followed in India.

In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.

This is a method of calculating margin after taking into account combined positions in futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-hedges.

In simple terms, long and short positions indicate whether you have a net over-bought position (long) or over-sold position (short).

A long position in futures can be closed out by selling futures, while a short position in futures can be closed out by buying futures on the exchange. Once position is closed out, only the net difference needs to be settled in cash, without any delivery of underlying. Most contracts are not held to expiry but closed out before that. If held until expiry, some are settled for cash and others for physical delivery.

Dr. L.C Gupta Committee had recommended that the level of initial margin required on a position should be related to the risk of loss on the position. The concept of value-at-risk should be used in calculating required level of initial margins. The initial margins should be large enough to cover the one day loss that can be encountered on the position on 99% of the days. The recommendations of the Dr. L.C Gupta Committee have been a guiding principle for SEBI in prescribing the margin computation & collection methodology to the Exchanges. With the introduction of various derivative products in the Indian securities markets, the margin computation methodology, especially for initial margin, has been modified to address the specific risk characteristics of the product. The margining methodology specified is consistent with the margining system used in developed financial & commodity derivative markets worldwide. The exchanges were given the freedom to either develop their own margin computation system or adapt the systems available internationally to the requirements of SEBI.

A portfolio based margining approach which takes an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and Single Stock Futures, has been prescribed. The initial margin requirements are required to be based on the worst case loss of a portfolio of an individual client to cover 99% VaR over a specified time horizon.

The worst scenario loss are required to be computed for a portfolio of a client and is calculated by valuing the portfolio under 16 scenarios of probable changes in the value and the volatility of the Index/ Individual Stocks. The options and futures positions in a client's portfolio are required to be valued by predicting the price and the volatility of the underlying over a specified horizon so that 99% of times the price and volatility so predicted does not exceed the maximum and minimum price or volatility scenario. In this manner initial margin of 99% VaR is achieved. The specified horizon is dependent on the time of collection of mark to market margin by the exchange.

The probable change in the price of the underlying over the specified horizon i.e. 'price scan range', in the case of Index futures and Index option contracts are based on three standard deviation (3s ) where 's ' is the volatility estimate of the Index. The volatility estimate 's ', is computed as per the Exponentially Weighted Moving Average methodology. This methodology has been prescribed by SEBI. In case of option and futures on individual stocks the price scan range is based on three and a half standard deviation (3.5s ) where 's ' is the daily volatility estimate of individual stock.

For Index Futures and Stock futures it is specified that a minimum margin of 5% and 7.5% would be charged. This means if for stock futures the 3.5s value falls below 7.5% then a minimum of 7.5% should be charged. This could be achieved by adjusting the price scan range.

The probable change in the volatility of the underlying i.e. 'volatility scan range' is fixed at 4% for Index options and is fixed at 10% for options on Individual stocks. The volatility scan range is applicable only for option products.

Calendar spreads are offsetting positions in two contracts in the same underlying across different expiry. In a portfolio based margining approach all calendar-spread positions automatically get a margin offset. However, risk arising due to difference in cost of carry or the 'basis risk' needs to be addressed. It is therefore specified that a calendar spread charge would be added to the worst scenario loss for arriving at the initial margin. For computing calendar spread charge, the system first identifies spread positions and then the spread charge which is 0.5% per month on the far leg of the spread with a minimum of 1% and maximum of 3%. Further, in the last three days of the expiry of the near leg of spread, both the legs of the calendar spread would be treated as separate individual positions.

In a portfolio of futures and options, the non-linear nature of options make short option positions most risky. Especially, short deep out of the money options, which are highly susceptible to, changes in prices of the underlying. Therefore a short option minimum charge has been specified. The short option minimum charge is 5% and 7.5 % of the notional value of all short Index option and stock option contracts respectively. The short option minimum charge is the initial margin if the sum of the worst -scenario loss and calendar spread charge is lower than the short option minimum charge.

To calculate volatility estimates the exchange are required to uses the methodology specified in the Prof J.R Varma Committee Report on Risk Containment Measures for Index Futures. Further, to calculated the option value the exchanges can use standard option pricing models - Black-Scholes, Binomial, Merton, Adesi-Whaley.

The initial margin is required to be computed on a real time basis and has two components:-

• The first is creation of risk arrays taking prices at discreet times taking latest prices and volatility estimates at the discreet times, which have been specified.

• The second is the application of the risk arrays on the actual portfolio positions to compute the portfolio values and the initial margin on a real time basis.

The initial margin so computed is deducted form the available Liquid Networth on a real time basis.

Options - The value of the option are calculated as the theoretical value of the option times the number of option contracts (positive for long options and negetive for short options). This Net Option Value is added to the Liquid Networth of the Clearing member. Thus MTM gains and losses on options are adjusted against the available liquid networth. The net option value is computed using the closing price of the option and are applied the next day.

Futures - The system computes the closing price of each series, which is used for computing mark to market settlement for cumulative net position. This margin is collected on T+1 in cash. Therefore, the exchange charges a higher initial margin by multiplying the price scan range of 3s & 3.5s with square root of 2, so that the initial margin is adequate to cover 99% VaR over a two days horizon.

Initial Margin - is adjusted from the available Liquid Networth of the Clearing Member on an online real time basis.

Futures contracts: The open positions (gross against clients and net of proprietary / self trading) in the futures contracts for each member is marked to market to the daily settlement price of the Futures contracts at the end of each trading day. The daily settlement price at the end of each day is the weighted average price of the last half an hour of the futures contract. The profits / losses arising from the difference between the trading price and the settlement price are collected / given to all the clearing members.

Option Contracts: The marked to market for Option contracts is computed and collected as part of the SPAN Margin in the form of Net Option Value. The SPAN Margin is collected on an online real time basis based on the data feeds given to the system at discrete time intervals.

Clearing Members and Trading Members are required to collect initial margins from all their clients. The collection of margins at client level in the derivative markets is essential as derivatives are leveraged products and non-collection of margins at the client level would provided zero cost leverage. In the derivative markets all money paid by the client towards margins is kept in trust with the Clearing House/ Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member.

Therefore, Clearing members are required to report on a daily basis details in respect of such margin amounts due and collected from their Trading members / clients clearing and settling through them. Trading members are also required to report on a daily basis details of the amount due and collected from their clients. The reporting of the collection of the margins by the clients is done electronically through the system at the end of each trading day. The reporting of collection of client level margins plays a crucial role not only in ensuring that members collect margin from clients but it also provides the clearing corporation with a record of the quantum of funds it has to keep in trust for the clients.

The position limits specified are as under-

For index based products there is a disclosure requirement for clients whose position exceeds 15% of the open interest of the market in index products.

For stock specific products the gross open position across all derivative contracts on a particular underlying of a customer/client should not exceed the higher of -

• 1% of the free float market capitalisation (in terms of number of shares). Or

• 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts).

This position limits are applicable on the combine position in all derivative contracts on an underlying stock at an exchange. The exchanges are required to achieve client level position monitoring in stages.

1. For Index products the Trading Member position limits are Rs. 100 cr or 15% of the open interest whichever is higher.

2. For stock specific products the trading member position limit are at 7.5% of the open interest or Rs 50 crore whichever is higher for derivative contract in a particular underlying at an exchange.

It is also specified that once a member reaches the position limit in a particular underlying then the member shall be permitted to take only offsetting positions (which result in lowering the open position of the member) in derivative contracts on that underlying. In the event that the position limit is breached due to the reduction in the overall open interest in the market, the member shall be permitted to take only offsetting positions (which result in lowering the open position of the member) in derivative contract in that underlying and no fresh positions shall be permitted. The position limit at trading member level are required to be be computed on a gross basis across all clients of the Trading member.

There are no market wide limits for index products. However for stock specific products the market wide limit of open positions (in terms of the number of underlying stock) on an option and futures contract on a particular underlying stock would be lower of -

• 30 times the average number of shares traded daily, during the previous calendar month, in the cash segment of the Exchange, or

• 10% of the number of shares held by non-promoters i.e. 10% of the free float, in terms of number of shares of a company.

It is further specified that when the total open interest in a contract reaches 80% of the market wide limit in that contract, the exchanges would double the price scan range and volatility scan range specified. The exchanges are required to continuously review the impact of this measure and take further proactive risk containment measures as may be appropriate, including, further increases in the scan ranges and levying additional margins.