What it means
Derivative positions change value constantly, so exchanges and clearing houses mark every position to market at the end of each day. The resulting profit or loss is exchanged in cash, which is the variation margin, and the position starts the next day with a clean slate.
This is different from initial margin, which is the good-faith deposit posted when you open a position. Initial margin sits there as collateral against future moves, while variation margin is the actual settlement of moves that have already happened.
For a business hedging commodity or currency exposure, variation margin is a cash flow issue rather than a profit issue. A hedge that is working exactly as designed still requires you to pay cash daily when the hedged price moves in the direction your physical business benefits from.
Failing to meet a variation margin call has immediate consequences. The clearing broker will normally close positions out rather than extend credit, which can crystallise a loss on a hedge that would have been fine had it been held to maturity.
Since post-crisis reforms, variation margin has also been required on many over-the-counter derivatives, not just exchange-traded futures. That has pushed corporate treasurers to keep dedicated liquidity buffers against the possibility of large calls.
The collateral itself is usually cash in the currency of the contract, though some bilateral agreements accept government bonds with a haircut applied. Whichever form is used, the transfer settles the day's move in full, so the exposure between the two parties resets to zero every evening.
In practice
Real-world examples.
Example
An airline hedges jet fuel with futures. Oil prices fall sharply, the hedge loses value, and the treasury team wires $4,200,000 of variation margin in a week, even though the airline is simultaneously saving far more than that on physical fuel purchases.
Example
A grain co-operative short wheat futures against its stored crop faces three consecutive days of rising prices. It draws on a pre-arranged $10,000,000 credit line specifically kept for margin calls, then repays it once the crop is sold and the hedge is closed.
Example
A pension fund using interest rate swaps to match its liabilities receives $6,800,000 of variation margin after rates move in its favour. The fund's collateral manager reinvests the cash in short-dated government bills rather than leaving it idle.
Think of it
“Variation margin is daily settlement of gains and losses-paying or receiving based on price moves.
Formula
Calculation
For a futures position:
Variation margin = Number of contracts x Contract multiplier x Price change
A fund is long 10 stock index futures contracts with a multiplier of $50 per index point. The index closes at 4,970 having settled the previous day at 5,000.
Price change = 5,000 - 4,970 = 30 points against the position
Variation margin owed = 10 x $50 x 30 = $15,000
The fund posted initial margin of $12,000 per contract, or $120,000 in total, and the maintenance level is $110,000. Paying the $15,000 loss would take the balance to $105,000, below the maintenance level, so the broker issues a call to restore the account to the full $120,000 initial requirement.Case study
Seen in the real world.
This illustrative and fictional example shows how the mechanics bite. Thornby Copperworks, an invented metals fabricator, hedged nine months of expected copper purchases by buying futures, locking in a price that protected its fixed-price customer contracts.
Copper then fell 18% over five weeks. The physical benefit was real, since Thornby would eventually buy metal more cheaply, but the futures position lost $3,600,000 and the clearing broker demanded that cash immediately in daily instalments.
Thornby had budgeted for the hedge but not for its timing, and the company came within days of breaching a bank covenant while waiting for the physical savings to arrive months later. After the episode it agreed a dedicated margin facility with its bank and modelled worst-case variation margin at the point each hedge was placed rather than afterwards.
Watch out
Common mistakes.
- Confusing variation margin with initial margin. Initial margin is collateral you post and get back, while variation margin is a genuine cash settlement of gains and losses that have already occurred.
- Assuming a perfect hedge needs no cash. The hedge and the physical exposure rarely settle at the same time, so a working hedge can still create a serious short-term funding gap.
- Treating variation margin payments as losses in management accounts. On a hedge they usually offset an equal and opposite gain on the underlying exposure, and reporting them alone gives a misleading picture.
Questions
People also ask.
How often is variation margin calculated?
Normally once a day after the close, though exchanges can and do make intraday calls when prices move sharply.
What happens if a variation margin call is not met?
The broker or clearing house has the right to close the position immediately and use the initial margin to cover the shortfall.
Does variation margin apply outside futures?
Yes, most cleared and many uncleared over-the-counter derivatives now require daily exchange of variation margin under post-crisis rules.
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