Exchanges are centralized places where certain securities, commodities, derivatives, and other financial instruments are traded. In order to facilitate trading among buyers and sellers of these products, exchanges take the central position of being the counterparty to both buyers and the sellers of the product. This is done to remove the possibility of disputes that may arise from the non-performance of the counterparty. The exchange guarantees trades will be honored. This creates credit risk for the exchange attributable to the buyers and the sellers of its products. To address the potential loss due to the credit risk undertaken by exchanges from these buyers and sellers of the exchange traded products, exchanges demand certain margin requirements from their counterparties. This presentation addresses in detail the issues that are considered for calculation of margin requirements and maintenance.

1. Rabinder K. Koul
Managing Director and Head of Risk Services
Gateway Partners

2. 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.

3. 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

4. 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

5. 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.

6. 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.

7. 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.

8. VaR (Value at Risk) Models
These 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.

9. 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.

10. 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

11. 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

12. 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.

13. 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)

14. 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.

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

16. 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.

17. 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.

18. 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.

19. 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:

20. 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.

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

22. 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.

23. 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%.

24. 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.

25. 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.

26. 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.