What is VM?
VM is a measure of the overall value of a portfolio from day to day. Here is a worked example:
- Each day your firm performs a valuation of all trades using current market prices and rates
- Each trade has positive or negative mark-to-market. Positive if the net value is in your favour, negative if not
- Add up the valuations of all trades between you and your counterparty to arrive at a single number representing the mark-to-market of the portfolio between your two firms
- Measure the change in value from one day to the next
- If the value goes up in your favour, call your counterparty for more margin
- If the value goes down, expect a call from your counterparty to return margin
The effect of calculating and calling for variation margin is to receive assets to the value of the current mark-to-market value of your portfolio as of the previous close of business. In theory this means that if your counterparty defaults, you have covered the market value of the portfolio with the collateral assets.
What VM doesn’t reflect is the wider range of possible profits and losses that might occur over the life of a portfolio, nor high risk market scenarios where the value of the portfolio may move by larger amounts. These situations are covered by Initial Margin.