A fresh take on risk and valuation
By Elias Bataire, Consultant, Valuation services
The initial margin (IM) and variation margin (VM) are the two mandatory types of collateral to protect a party to a trade in the event of default by the counterparty. The IM is defined as an amount that “covers potential future exposure for the expected time between the last VM exchange and the liquidation of positions on the default of a counterparty”. Thus, as both parties are exposed to mark-to-market evolution when dealing a trade, the IM must be bilaterally posted and collected (each party pays and receives at the same time) in order to be protected against potential future exposures.
For calculating the IM, the ISDA standard initial margin model (SIMM) has been developed for non-cleared derivatives as settled by the BCBS-IOSCO guidelines. The aim of this methodology is to increase the efficiency through netting exposures and the reconciliation process to resolve differences in IM values. The model applies a sensitivity-based calculation within four product types: equity, interest rates and foreign exchange, credit, and commodities. Sensitivities are used as inputs into aggregation formulae tailored to identify hedging and diversification benefits of trades according to specific risk factors and matrices.
The collection of IM is generally consistent for the scope of non-cleared derivatives across the principal jurisdictions in Europe, US, and Asia. However, a specific jurisdiction can have some exclusions: e.g., equity options are excluded until January 2021 in the EU. When the netting set consists of options under the EU jurisdiction, “the option seller should be able to choose not to collect initial or variation margins for these types of OTC derivatives as long as the option seller is not exposed to any credit risk. The counterparty paying the premium (‘option buyer’) should however collect both initial and variation margins”. Thereby,
even if the option seller does not face any potential future exposure with the premium paid, the option buyer is still required to post the IM and VM, unless he is able to isolate this trade from other potential future exposures with the option seller.
To achieve this, the option buyer with zero counterparty risk could use the practical solution to enter into specific CSA to isolate the option from other trades following an explicit agreement with the option seller willing not to collect the IM and VM. Nevertheless, this practice leads to extra costs for the market participants and can be avoided if the option buyer posts the IM despite the fact that he has no counterparty risk.
In the case of an option buyer who must still post the IM alongside the option seller, an asymmetry in the amount posted and collected will arise. Typical discrepancies due to the premium and calculation currency being laid aside, differences will appear from the computation of the curvature margin component of the ISDA SIMM methodology
The curvature margin captures the second order sensitivity of the trade and is approximated by the inputs of delta and vega sensitivities. The formulae take into account the fact that the market participant is either the secured party or the pledger by looking at the sign of the sensitivities and lead to a different IM amount. As a consequence, for an option buyer being requested to post the IM, the amounts paid and collected will face discrepancies coming not only from the option premium paid but also from the asymmetry of the curvature margin.
the IM protects against potential future exposure for the forecasted time between the last VM exchange and the positions liquidation for a counterparty in default. Even if an option buyer has no counterparty risk when paying the premium, he is still required to post the IM for this specific trade. The practical solution for the option buyer not to post the IM is to create specific CSA in order to isolate the option from other trades of the option seller (explicit agreement) but this will lead to extra costs. Finally, an option buyer who must post the IM will face asymmetry with the amount collected because of the curvature margin of the trade.