How Margins Are Calculated Using Value at Risk (VaR)

There are many organizations in the world that have billions of dollars invested in the financial markets. Most of these organizations provide financial services. However, a lot of other cash-rich companies also have a lot of money invested both in the cash as well as the derivative segments. Hence, these companies face the risk that a change in the market price will negatively impact their position.

For instance, if a counterparty backs out of a contract because of a price decline, it could impact the other counterparty. This risk is like a hybrid between credit risk and market risk. This is because the action of default will be done by a counterparty i.e. credit risk whereas the event that might trigger the default will be the result of market trading i.e. market risk. The margin system has been defined in order to help organizations mitigate this risk.

In this article, we will have a closer look at what the margin system is and how organizations can use it to their advantage.

What is the Margin System?

The margin system is a mechanism wherein one party makes a partial payment to another party in order to take a position in an underlying asset. For instance, if an organization wants to buy 100 shares worth $10 each, then it will have to pay $1000 to the seller. However, it is possible that the organization does not have the funds but wants to take the position.

In such cases, the organization can pay a margin amount of let's say $100 and take a position of $1000. Now, when the value of the underlying security fluctuates up to $100, the margin will absorb those losses. However, if the losses are about to exceed $100, then more margin will have to be paid in. This is called a margin call. The purpose of the margin system is to ensure that at any given point in time, the amount of loss should not exceed the margin. It is also important to know that if the contract being traded is on the exchange, then the exchange will be the counterparty to all these transactions.

Types of Margins

The margin system is linked to market risk management because the calculation of the margins is done on the basis of value at risk (VaR). There are two types of margins that are commonly used. In day-to-day transactions, the margin value payable is a sum of both these margins.

1. VaR Margin: We have already studied the concept of value at risk (VaR) in the previous articles. VaR denotes the maximum possible loss that can happen in a day based on empirical data. The predictions are made with different confidence levels. In order to calculate margin, a 99% confidence level is used. Hence, VaR denotes the possibility of loss in normal circumstances i.e. if no black swan event takes place.

2. Extreme Risk Margin: Another form of margin called the extreme risk margin is used to calculate the loss that is likely to arise if a black swan event indeed takes place. The common method to calculate extreme loss margin is to multiply the standard deviation by 1.5. Hence, empirical data used to calculate the VaR margin is also used to find the standard deviation. For instance, the data may reveal that the standard deviation is 4%. Hence, in such cases, the extreme loss margin will be 4% multiplied by 1.5 which is 6%. In many parts of the world, the extreme loss margin is capped at 5%. Hence, in the above-mentioned case, even though the formula suggests a 6% extreme loss margin, the amount taken from the buyer will be 5%.

Hence, the total margin amount taken from investors is the sum of both the margins. If the VaR margin is 4% and the extreme loss margin is 5%, then investors will have to pay a total of 9% margin.

Why is Value at Risk (VaR) Important in Margin Calculation?

The concept of value at risk (VaR) helps in ensuring that the correct amount of margin is collected from the investors. There is always a probability of collecting too much or too little margin from investors and both have their own side effects.

Collecting too much margin would lead to resources being locked down and investors would not be able to take the maximum leverage. On the other hand, if too little margin is collected, the counterparty may not be able to pay if an adverse event takes place. This will break down the trust in the system.

The value at risk (VaR) methodology uses statistics to come up with the ideal amount of money that must be taken from investors which provides safety and efficiency to both parties. It ensures that the margin taken from investors is proportionate to the risks they are taking. If the margin is not calculated using VaR and instead a flat rate is levied, then it will incentivize people who take unnecessary risks and disincentivize people who buy conservative stocks.

In essence, people buying conservative stocks will be subsidizing the people who buy extremely risk stocks. The VaR system, therefore, makes the numbers more rational and improves the overall efficiency of the system.