One of the challenges that comes with using deriviatives to manage price risk is the requirement to manage and finance margins, which can be done by using broker lines and margin funding. In this article, we take a look at margining in more detail and also how it can be financed.
What is Margining?
Margins are a collateral provided by traders to the exchange to insure against contract default. ‘To margin’ also refers to borrowing money from a broker in order to provide this collateral. Margining is therefore in short, the practice of using funds from either a broker line or indeed a company’s other financial facilities to trade a commodity which forms the collateral for the loan from the broker. In this way, using broker lines allows a company to trade more of a commodity than they would be able to normally with the balance in its account.
The exchange requires margins and they are adjusted on a daily basis after the market has closed through a process called ‘marking to market’. Therefore, whenever a trader enters a future position, they will be required to pay some margin to the exchange. The first payment is known as ‘initial margin’ which acts a down payment for the delivery of the contract and ensures that the parties honour their positions.
Once a company has set up a margin account with a broker, then money can be lent from the broker to the company for the initial margin. A company can borrow up to a certain specified amount of the purchase price of a commodity for example. The initial margin therefore represents the percentage of the purchase price of a commodity which the company’s own funds are required to cover, and the rest may be borrowed from the broker. This loan from the broker can be kept as long as a company wants so long as it fulfils its contract obligations by paying interest on time on the borrowed funds. However, as debt levels increase over time as interest charges accrue against a company, the odds that a profit will be made is stacked against a company who holds an investment on margin for an extended period of time thus margining usually tends to be for short-term investments.
The maintenance margin refers to the amount of equity which must be maintained in the margin account in order to keep the position open after the purchase has been made as the balance changes due to price fluctuations. The minimum amount for a maintenance margin is 25% set by Regulation T but may brokerage firms tend to ask for a higher percentage. Should the balance in a trader’s account drop below this margin, the trader would then receive a ‘margin call’ from the brokerage firm. The margin call signifies that the trader is required to deposit enough funds into their account to meet the initial margin requirement again. In this way, the maintenance margin helps protect brokerage firms from traders defaulting their loans and offsets risk. Should the trader be unable to meet the margin call, the brokerage firm could then sell the collateral in the account until the amount is met or until the risk is reduced to an acceptable level.
The variation margin is the amount of funds which brings the trader’s account balance back up to the initial margin if it drops below the maintenance margin.
Margin funding has become an important financing option and is now a common tool for investors and traders to carry out transactions, even without possessing the entire funds required for such deals. It is a common means of solving fund shortfalls faced during trading and therefore is extremely essential and useful for commodities companies, such as Czarnikow. The wide range of facilities available to Czarnikow (see our Annual Review for more information), also allows us to support our clients with price risk management tools, without the client themselves needing to undertake the whole process of managing and financing margin requirements.
Author: Betty Rook
Images: Charles Deluvio, Mikita Yo,