Margining methodology
This document aims to provide a short but comprehensive summary of the margining methodology used by the JSE. Full technical specifications and examples can be obtained by contacting the Risk Manager.
The Portfolio Scanning method is used. Many different variations of this method are used by derivatives exchanges world-wide.
The basis of Portfolio Scanning is that the whole of a participant's portfolio on the exchange is valued ("scanned") at a number of points over a wide range of market moves. The range is selected to cover almost all conceivable market moves within the next day. The lowest of the portfolio values is identified and from this is found the greatest loss which the participant could suffer on the next day. The initial margin, due in cash the next morning, is then set equal to this greatest loss.
The responsibility for setting margin parameters and the extent of the market moves lie with the exchange's Risk Management Committee, RMCO. Each clearing member has a seat on the RMCO. The clearing members underwrite the exchange and therefore ,have a direct interest in its risk management.
RMCO expresses its attitude to risk in the fundamental margining parameter, namely the "Risk Parameter". This is measured in standard deviations ("Sds") and has been set at 3.5 Sds since the margining methodology was introduced.
The Risk Parameter determines the width of the range over which prices are scanned. An underlying assumption is that prices are lognormality distributed. Given the standard deviation of such a distribution - in other words, the volatility of the price - the price move corresponding to 3.5 Sds can be found. The scanning range then covers moves up and down of this amount from the mark-to-market price.
The Risk Parameter of 3.5 Sds corresponds to a confidence level of 99.95%. The chance that larger moves will occur in practice - which means that margins will be insufficient to cover losses - is, at 3.5 Sds and under the assumption of lognormality, 1 in 2,000 in any day, and 1 in 9 over a whole year.
However, should it appear during a day that such a larger price move is going to happen, the Exchange can resort to the next line of defense. This is the "intra-day margin call", in which all positions are marked-to-market and margins are recalculated, resulting in cash calls for immediate settlement.
Given the mark-to-market price of a futures contract and its volatility, the 3.5 Sd price move is found each day. This is converted to the gain or loss on a one-contract short or long position.
This figure gives a "theoretical" margin requirement, which is an unrounded amount that would tend to fluctuate from day to day. In order that margins are round figures which are not subject to too frequent changes, RMCO lays down certain "trigger steps" for each contract. The process is illustrated in the graph below:
The actual Initial Margin Requirement (IMR) is initially set to be the multiple of the trigger step above the theoretical value. If on a subsequent day the theoretical value moves above this "upper trigger", the IMR is moved up a step. If the theoretical value moves below this"lower trigger" the IMR is moved down a step.
The process of finding IMRs requires a volatility for each contract on each day. The volatility to be used has been defined by RMCO as the larger of the long-term volatility trend and the overnight market volatility. The long-term volatility trend is calculated as the 750-day (three year) exponential volatility, of daily historical closing prices. The overnight market volatility is derived from the implied volatilies of at-the-money options quoted on the futures, where these exist. Where options exist on more than one expiry month, a weighted linear regression is performed to allow for the term-structure of volatility in finding the overnight volatility. If options do not exist on a contract, the contract's own 30-day exponential historical volatility of the contract is used as a surrogate for the overnight market volatility.
The description above has concentrated on price scenarios - i.e. the construction of the different prices (and in particular the extreme prices) at which portfolios are scanned.
Where portfolios contain options, they are also scanned over varying volatilities.
There are two sets of scenarios, known as "volatility up" and "volatility down". These are found from the market volatility plus or minus the Volatility Scanning Range (VSR) which is a margining parameter set by RMCO for each series of contracts.
In addition, and adjustment is made for the effect [the "Range Price Volatility Effect" (RPVE)] which large price moves would have on volatility. Volatilities in both scenarios are increased for prices far from the market (to an extent, this also allows for the risk arising from the so-called "volatility smile"). The RPVE is more marked for the shorter contracts.
Offsets are allowed between positions in all expiry months in each series of contracts. Each expiry has a RMCO - defined parameter, namely its Class Spread Margin Requirement (CSMR). This is calculated from a statistical analysis of correlation and the Risk Parameter. For a simple "long March, short June" position the process is quite easy. The net margin will be the positive difference between the IMR's of the two positions IMR's (the effect of offsetting), plus each of their CSMRs (the effect of spreading), as shown in the example below.
Contract
| Position
| IMR/Contract | IMR | CSMR/Contract
| CSMR | Total Margin
|
March
| +10 | R350 | R3,500 | R25 | R250 | |
| June | -10 | R400 | R4,000 | R25 | R250 | |
| | | | R500 | + | R500 | R1,000 |
Where a position contains options or a less straightforward mix of contracts, the calculation becomes more complicated. The effect, however, is always to attempt to optimise the use of capital by minimising the amount of margin due. This is achieved by bringing into the process only those portions of positions for which offsetting and spreading produces a net benefit. In addition to offsetting between contract months, offsets are allowed between net positions in groups of contracts which show sufficient correlation, for example the Dollar/Rand, Euro/Rand, Sterling/Rand or ALSI/FINI/INDI groups. The calculations follow the same approach as above; the relevant margin parameters are the Series Margin Requirements, or SSMRs.
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