Margin, Collateral and Counterparty Risk
Core concepts
Margin protects the clearing system against default. Know initial margin (posted at inception, covers potential future exposure over the close-out period), variation margin (daily cash settlement of mark-to-market moves), and maintenance margin (the threshold below which a call is triggered). Understand the margin call process, close-out netting, and the default waterfall: defaulter's margin → defaulter's default fund contribution → CCP capital and mutualised default fund → assessment powers.
Learn collateral: eligible assets, haircuts, concentration limits, and the difference between variation margin (settles current exposure) and initial margin (covers future exposure). Know counterparty credit risk: current exposure plus potential future exposure, credit valuation adjustment (CVA), and the role of collateral in reducing exposure.
Traps
Questions often confuse maintenance margin with initial margin: a breach of maintenance triggers a call back to the initial level. Another trap is assuming margin eliminates risk - it reduces but does not remove counterparty and liquidity risk. Watch for haircut direction: higher haircut means lower collateral value and more collateral required.
Worked example
A trader posts initial margin of 10,000 with maintenance at 7,000. A loss of 4,000 brings equity to 6,000, below maintenance. The call restores equity to the initial level of 10,000, so the trader must pay 4,000, not 3,000 (the amount to reach maintenance).
Rule of thumb
Margin calls restore equity to the initial margin level, not the maintenance level. Collateral value = market value × (1 − haircut).