Why have IM?
Initial Margin is a term which originates in the exchange-traded market. When trading on an exchange each contract has a specific Initial Margin amount which must be deposited with the exchange to cover potential losses resulting from your counterparty's default. With OTC Derivatives it has become a misnomer, a better name might be "Portfolio Risk Margin" or "Scenario Risk Margin" or "Future Potential Losses Margin" which are nearer to the definition.
Initial Margin is calculated to cover the possible losses over a period of time from a default event to eventual close-out or hedging of your positions.
Imagine this sequence:
- Day 1: Your counterparty defaults. The default causes fears in the market and the price of swaps drops. You begin the process to liquidate the counterparty assets
- Day 2: You will have decided how to handle the defaulted portfolio, whether to hedge the portfolio to re-balance your risk, or to sell the positions and close them out. Either process takes time, and the swap market may still be dropping
- Days 3,4,5: Hedging or selling carries on until complete, in a volatile market
- Day 6: Process complete. The costs of placing hedges or any losses from closing the portfolio should be covered by the liquidation of assets on day 1
The factors that IM covers are:
- An uncertain period over which the portfolio is hedged or sold
- An uncertain swap market during which the process takes place
- An uncertain value of the entire portfolio
Key terms related to Initial Margin are:
Holding Period Scenarios VaR Simulation
Variation Margin could be regarded as a very short term form of IM with only a 1 day period. VM covers the loss if your counterparty fails to pay the change in the net portfolio value as of last close of business. In comparison IM may cover a 5 or 10 day period.
Any losses on a portfolio in a distressed market could far exceed the Variation Margin you are holding. Initial Margin bridges this gap and is intended to cover a wider range of loss scenarios.