Understanding Margins
Why should there be margins?
Just as we are faced with day to day uncertainties pertaining to weather, health,
traffic etc and take steps to minimize the uncertainties, so also in the stock markets,
there is uncertainty in the movement of share prices. This uncertainty leading to
risk is sought to be addressed by margining systems of stock markets.
Suppose an investor, purchases 1000 shares of ‘xyz’ company at Rs.100/- on
January 1, 2008. Investor has to give the purchase amount of Rs.1,00,000/- (1000
x 100) to his broker on or before January 2, 2008. Broker, in turn, has to give this
money to stock exchange on January 3, 2008.
There is always a small chance that the investor may not be able to bring the
required money by required date. As an advance for buying the shares, investor is
required to pay a portion of the total amount of Rs.1,00,000/- to the broker at the
time of placing the buy order. Stock exchange in turn collects similar amount from
the broker upon execution of the order. This initial token payment is called
margin.
Remember, for every buyer there is a seller and if the buyer does not bring the
money, seller may not get his / her money and vice versa. Therefore, margin is
levied on the seller also to ensure that he / she gives the 100 shares sold to the
broker who in turn gives it to the stock exchange. Margin payments ensure that
each investor is serious about buying or selling shares.
In the above example, assume that margin was 15%. That is investor has to give
Rs.15,000/-(15% of Rs.1,00,000/) to the broker before buying. Now suppose that
Investor bought the shares at 11 am on January 1, 2008. Assume that by the end of
the day price of the share falls by Rs.25/-. That is total value of the shares has
come down to Rs.75,000/-. That is buyer has suffered a notional loss of
Rs.25,000/-. In our example buyer has paid Rs.15,000/- as margin but the notional
loss, because of fall in price, is Rs.25,000/-. That is notional loss is more than the
margin given.
In such a situation, the buyer may not want to pay Rs.1,00,000/- for the shares
whose value has come down to Rs.75,000/-. Similarly, if the price has gone up by
Rs.25/-, the seller may not want to give the shares at Rs.1,00,000/-. To ensure that
both buyers and sellers fulfill their obligations irrespective of price movements,
notional losses are also need to be collected. Prices of shares keep on moving every
day. Margins ensure that buyers bring money and sellers bring shares to complete
their obligations even though the prices have moved down or up.
What is volatility?
Different people have different definitions for volatility. For our purpose, we can
say that volatility essentially refers to uncertainty arising out of price changes of
shares.
What is the difference between price movements and volatility?
Prices of shares fluctuate depending on the future prospects of the company. We
hear of stock prices going up or down in the markets every day. Popularly, a share
is said to be volatile if the prices move by large percentages up and/or down. A
stock with very little movement in its price would have lower volatility.
What are the types of margins levied in the cash market segment?
Margins in the cash market segment comprise of the following three types:
1) Value at Risk (VaR) margin
2) Extreme loss margin
3) Mark to market Margin
What is Value at Risk (VaR) margin?
VaR Margin is at the heart of margining system for the cash market segment. VaR
margin is collected on upfront basis. In that respect, it is similar to the margin we
have seen in our example under question 1 while placing the order. The most
popular and traditional measure of uncertainty / risk is Volatility, which we have
understood earlier. VaR is a technique used to estimate the probability of loss of
value of an asset or group of assets (for example, a share or a portfolio of a few
shares), based on the statistical analysis of historical price trends and volatilities.
A VaR statistic has three components: a time period, a confidence level and a loss
amount (or loss percentage). Keep these three parts in mind and identify them in
the following example:
With 99% confidence, what is the maximum value that an asset or portfolio
may loose over the next day?
You can see how the "VaR question" has three elements: a relatively high level of
confidence (99%), a time period (a day) and an estimate of loss (expressed either in
rupees or percentage terms). VaR is computed using exponentially weighted
moving average (EWMA) methodology.
How is the Extreme Loss Margin computed?
The extreme loss margin aims at covering the losses that could occur outside the
coverage of VaR margins. The Extreme loss margin for any stock is higher of 1.5
times the standard deviation of daily LN returns of the stock price in the last six
months or 5% of the value of the position. This margin rate is fixed at the
beginning of every month, by taking the price data on a rolling basis for the past
six months.
How is Mark-to-Market (MTM) margin computed?
MTM is calculated at the end of the day on all open positions by comparing
transaction price with the closing price of the share for the day. In our example in
question number 1, we have seen that a buyer purchased 1000 shares @ Rs.100/-
at 11 am on January 1, 2008. If close price of the shares on that day happens to
be Rs.75/-, then the buyer faces a notional loss of Rs.25,000/- on his buy position.
In technical terms this loss is called as MTM loss and is payable by January 2,
2008 (that is next day of the trade) before the trading begins. In case price of the
share falls further by the end of January 2, 2008 to Rs. 70/-, then buy position
would show a further loss of Rs.5,000/-. This MTM loss is payable by next day.
In case, on a given day, buy and sell quantity in a share are equal, that is net
quantity position is zero, but there could still be a notional loss / gain (due to
difference between the buy and sell values), such notional loss also is considered
for calculating the MTM payable.
MTM Profit/Loss = [(Total Buy Qty X Close price) – Total Buy Value] - [Total
Sale Value - (Total Sale Qty X Close price)]
