We’ve spoken before about how margin multipliers can be used to challenge margin calls. But they are not the only things that can lead to issues with the level of requirements you might be asked to post.
Many treasury solutions are operationally focused, providing the workflow to ensure that margin calls are met in a timely fashion and that processes are as efficient as possible. However, this is on the assumption that the amounts being requested are correct and could mean that overpayments are being made. To combat this, firms should look to include analysis within the process that allows the calculations to be validated so that brokers can be challenged if the numbers are incorrect.
So what, apart from account style multipliers such as those applied to speculator accounts, is likely to be a factor in incorrect margin calculation? Below we consider the most common problems.
Issues With The Contract Size
Most margin calculations rely on scaling, based on the size of the contract in question, to convert theoretical price moves into profits or losses. But what this scalar should be isn’t always obvious.
For Fixed Income products, there can be confusion between the notional for a contract and the scalar to be applied, which is not the same. For example, bond contracts tend to be based on 100,000 notional, but because of the way that prices are defined this equates to a contract size of 1,000.
For interest rate futures the size of the contract is potentially even harder to understand. Euro Dollar futures, for example, have a contract size of $25 per basis point. This is based on the assumption of the likely return on a $1,000,000 deposit on a 3 month rate – $25 per bp = ($1 million) x (0.01 pct per yr) x (90 days / 360 days per yr).
However, this is per basis point. But generally the contracts are traded with a minimum price fluctuation of half a basis point, which would imply $12.50 as a multiplier. But the price is quoted in decimals, with 1 basis point equal to 0.01, so the contract size that applies in most calculations is $2,500 per lot. That is a lot of alternatives and potential for issues.
Energy contracts can be even more confusing. Sometimes there is a conversion to be made between the units in which the contract is traded and the units in which it delivers. For example, UK Natural Gas trades in therms but is delivered in kWh.
Even more likely to be the source of errors are the gas and power contracts that are dependent on the number of hours in the day or days in a month. It’s amazing how many people forget that some days can be 23 or 25 hours long, or that 28, 29, 30 and 31 are all valid lengths of months. Combine these together and you can see how the wrong contract size can be applied.
Missing Positions
Missing positions are an obvious source of errors in margin calculations. There are many possible reasons, but timing is an important one especially if you are looking at intra day calculations.
The normal assumptions would be that missing positions lead to lower rather than higher margin. However, the missing positions can be a hedge with other parts of the portfolio and the fact that they are missing results in a higher margin.
Incorrect Handling Of Expiring Contracts
Knowing when to remove expiring positions from a portfolio is another source of potential errors. They may be removed too early, resulting in the same effect as missing positions. Alternatively, they may not be removed on time, meaning that margin may continue to be calculated.
Contracts that deliver over a period of time can be a particular issue in this context. Some allow multiple days to be the delivery day which can easily lead to records being out of step. But it is the gas and power contracts that deliver every day over the delivery month that can cause the biggest problems. Knowing what should be included in the margin calculation, and when, is prone to errors.
Incorrect Market Data
The prices used in the margin calculation may be incorrect. For example a broker may use the previous day’s price if the updated prices are not received from the CCP by a specified time. Alternatively errors can occur that result, for example, in the price for the wrong expiry being used or the assumption being made that a price in pence (GBX) is in pounds (GBP), leading to a 100 times error.
Similarly the parameters used in a margin calculation may be wrong. In addition, the data provided in the CCP files may be incorrect causing sudden jumps in the requirements calculated, for example by wrongly stating the confidence level to use in a VaR calculation. Errors in the provided settlement style for a contract can have unintended consequences, including calculating margin components that are not appropriate.
What Can You Do?
Nobody wants to pay too much margin and the first step in ensuring this is the case is to validate that the amount you are being called for is correct. To do this you need a solution that provides the tools to enable you to perform an independent calculation and compare this with the reports provided by your broker. The potential benefits can be significant.
