Case 001Margin, clearing and risk limitsWarm up

A client buys 10 lots of index futures at 22,000 and the daily settlement price moves for five days. Walk through each day's variation margin and the running total.

The situation

A client of Dhamni Broking buys 10 lots of Satpura 50 futures at 22,000. One lot is 50 units of the index, so the position is 500 units and the notional is 22,000 times 500, Rs 1.1 crore. The exchange collects an initial margin that for this example is 10% of notional, Rs 11 lakh, which the client has posted.

The daily settlement prices over the next five days are 21,850, 21,700, 21,900, 22,150 and 22,050. The client does not trade again during the week.

Your task

Compute the variation margin that flows in or out on each day, the running total, and tell the client what the week cost in cash and why.

Quick check

Before adding anything up: over the five days, is the client's net variation margin positive or negative?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The five flows are minus Rs 75,000, minus Rs 75,000, plus Rs 1,00,000, plus Rs 1,25,000 and minus Rs 50,000, which add to plus Rs 25,000. Every day the exchange marks the position to the settlement price and moves the difference in cash. The total is just 22,050 less 22,000 on 500 units. But the client was down Rs 1,50,000 after day two and had to fund that in cash before the gains arrived, which is why the path matters even when the total is small.

Step 1What exactly is settled each day?

Think of a running tab at a canteen that is settled every evening rather than at the end of the month: the total you pay is the same, but you need the cash each day. A futures position is settled the same way: each evening the exchange marks it to that day's settlement price and the whole change, on the full 500 units, moves in cash. On day one the price falls 150 points from the 22,000 purchase price, so 150 times 500, Rs 75,000, leaves the client's account. On day two it falls another 150 to 21,700 and a second Rs 75,000 leaves. The client has not sold anything, yet Rs 1,50,000 is gone, because the variation marginThe daily cash transfer equal to the change in the value of a futures position, paid by the losing side to the winning side through the clearing house. is a real transfer, not a book entry.

Daily variation margin on 500 units bought at 22,000, and the running total0-75,000Day 121,850-75,000-75,000Day 221,700-1,50,000+1,00,000Day 321,900-50,000+1,25,000Day 422,150+75,000-50,000Day 522,050+25,000Settles atRunninglowest point: cash neededFive flows add up to+25,000= (22,050 - 22,000) x 500 unitsbut by day 2 the client had paid-1,50,000in cash before any gain arrivedPosition notional22,000 x 500 = Rs 1.1 crorethe swings are on this, not on the margin
On 500 units bought at 22,000 the daily flows are minus Rs 75,000, minus Rs 75,000, plus Rs 1,00,000, plus Rs 1,25,000 and minus Rs 50,000, and the running total touches minus Rs 1,50,000 after day two before ending at plus Rs 25,000, which equals the 50 point rise times 500 units.
Step 2Why does the running total end exactly at the price change?

Each day's flow is settlement price today minus settlement price yesterday, times units. When you add five such differences, every intermediate price cancels and only the last settlement less the entry price survives: 22,050 minus 22,000, times 500, is plus Rs 25,000. That is why the quiz above did not need the daily numbers. Day three brings 200 points back, Rs 1,00,000, day four adds 250 points, Rs 1,25,000, and day five gives back 100 points, Rs 50,000. The running total goes minus 75,000, minus 1,50,000, minus 50,000, plus 75,000, plus 25,000.

DaySettlementChange, pointsVariation margin, RsRunning total, Rs
121,850-150-75,000-75,000
221,700-150-75,000-1,50,000
321,900+2001,00,000-50,000
422,150+2501,25,00075,000
522,050-100-50,00025,000
Week+5025,00025,000
Each day's flow is the change in settlement price times 500 units; the five flows add to plus Rs 25,000, the 50 point move from 22,000 to 22,050, and the lowest running total is minus Rs 1,50,000 after day two.
Step 3What do you tell the client about the week?

Say the two numbers in order: the week made Rs 25,000, and it needed Rs 1,50,000 of cash on the way. The initial margin of Rs 11 lakh is collateral against future moves; it is not a buffer the client can lose quietly, because once the losses erode it the broker calls for a top-up or cuts the position. A client who had exactly the initial margin and nothing spare would have received a margin call on day one and a larger one on day two, and a broker that squares off unfunded positions would have closed the trade at 21,700, just before the recovery. The lesson is that the notional is Rs 1.1 crore and the daily swings are on that figure, so cash planning has to be done on the notional, not on the margin posted.

Say the limit too. The arithmetic here ignores the interest on the margin held and any change in the margin rate during the week; in a volatile week the exchange can raise the initial margin, which adds a second cash call on top of the variation margin.

Where candidates lose it

The common loss is to compute the mark-to-market against the entry price each day and report cumulative figures as if they were daily flows, so day three becomes minus Rs 50,000 instead of plus Rs 1,00,000. Variation margin is always today's settlement against yesterday's.

The second is to answer that the week made Rs 25,000 and stop. The interviewer wants the minus Rs 1,50,000 on day two, because that is the number that decides whether the client survives to collect the gain.

What the interviewer asks next

  • The exchange raises initial margin to 14% on the evening of day two. What is the client's total cash call that night?
  • If the client had sold instead of bought, what would the running total look like?
  • Why does a futures position have variation margin while a forward with the same payoff does not?
  • What is the counterparty risk left after daily settlement, and who bears it?

Company names and figures are illustrative.