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Margins

When the two counterparts engage into a futures contract, there are risks concerning the ability of the party with the long position to pay on the delivery day. On the other hand, there is a risk that a party with a short position can be found, which will not be able to honor the delivery. Margins are set in order to minimize the risks of default.

The margin is cash [or marketable securities] deposited by an investor with her broker. Both parties [with long and short positions] are required to keep a margin account. The balance of the margin is adjusted on a daily basis, in order to reflect the futures price movements. If the investor has a long position and the price declines, the broker will draw that money from the margin account. The broker will pass this money to the exchange, which in turn will pass it to the broker dealing with the short position in order to increase the margin account of the counterpart with the short position. This procedure is illustrated in diagram 2.2

\begin{figure}\par% \providecommand{\li}{%% \begin{tabular}{c} Long \\ inve... ...gin \\ account \end{tabular}} %% \end{tabular}\end{center}\par\end{figure}

The investor has the right to withdraw any amount of many which exceeds the margin. In the previous example, the party with the short position can do so. If the futures price continues to decline, there is the possibility that the margin will become negative. To prevent that, a maintenance margin is set, which is an amount lower than the margin itself. If the margin account falls below this maintenance margin, the investor receives a margin call and has to top up the margin account. If the investor does not meet this obligation within a short period of time, the broker will sell the contracts and close the position. In that way the risk of default is minimized.

The ``exchange'' above is in fact the exchange clearinghouse which acts as a middleman in futures transactions, and has a number of members. If a broker is not a member, she has to channel her transactions through a member and of course keep a margin account there. Even clearinghouse members are required to keep a margin account, which is called the clearing margin, but not maintenance accounts. Usually clearing is done on a net margining basis: every clearinghouse member first offsets the short and long positions they deal with against each other, and then calculate their clearing margin.

next up previous contents
Next: Open interest and volume Up: Hedging with Futures Previous: Specifications   Contents
Kyriakos 2003-03-17