In maintenance margin questions,the assumption is that the investor will take out the profit or?

[Steve Jobs]

A sample question by me:

Investor is long;
Initial margin = 4, Maintenance margin = 2

Sunday price = 10
Monday price = 12
Tuesday price = 7

On Tuesday, should the investor pay a variation margin?

I think the answer depends on whether the investor had taken out the profit from his account at Monday marking to market or no; am I correct? if yes, then why on many FRM practice question, this information is not provided?

 

[ShaktiRathore]

On Monday: gain= 2
On Tuesday: loss= -5
so even if investor has not taken out profit the net loss of 3 will drop the initial margin to 1 that is below maintenance margin so investor will need to pay a variation margin on Tuesday. Its assumed i think that investor takes out the profit after each settlement on the trading day. The profit goes to the account of the investor and will not affect the initial margin.

thanks

 

[Steve Jobs]

Thanks Shakti,

So I understand that if the question is asking about frequency of margin calls, then all we have to do is to calculate the difference between each day's price, and the accumulative gain/loss which is sometimes provided in the question or calculated in the provided answers of sample question, is irrelevant.

As you mentioned, this might imply that the gain is transferred to another account or that the investor will withdraw the gain in the same day. Is it like that reality?

 

[ShaktiRathore]

Hi
Yes if the margin falls below maintenance margin than investor receives a margin call whereby he has to restore the initial margin to the initial margin level required. So if margin required is say 40 and due to heavy losses the margin falls to 20 which is below the maintenance margin of say 25 than the investor needs to restore the margin up by 40-20 =20 to the initial margin level of 40. The investor can meet these margin calls from his own account or from the accumulated profits if investor does not meet the call than the positions are closed.
Reality should be somewhat closer to it. However the actual mechanics through which the futures trading happens is beyond my theoretical understanding. You can always refer to some sound text on these futures trading looking at the practical side of it. But theory should not be far from practice.
thanks

 

[David Harper CFA FRM]

Steve, It is a a great insight, I do not think GARP has addressed this explicitly. (I am going to add a note for submission to GARP's research director).

I agree with Shakti except for his understandable statement that "It's assumed i think that investor takes out the profit after each settlement." The reason this is debatable is:

• Assuming withdrawal of excess margin is consistent with the later convexity bias assumption; i.e., futures prices differ from forward because there is interim cash flow due to both marginal calls and excess margin withdrawal. In this way, Shakti's assumptions seems totally consistent
• However, Hull says in his example (table 2.1. where note he does have three days of excess margin) "Note that the investor has excess margin on Days 8, 13, 14, and 15. It is assumed that the excess is not withdrawn."-- Hull Chapter 2, page 29. I frankly think that, in the context of margin requirements, it is more natural to assume the excess margin is NOT withdrawn unless otherwise specified.

It's a great point because while, to Shakti's point, it does matter for Steve's example, if we tweak it slightly to:

Sunday P = 10,
Monday P = 12,
Tue P = 9

Then it seems to matter, given initial = 4 and maintain = 2:

• If we do withdraw the excess 2 on Mon, then balance on Tue = 4 - 3 = 1, requiring a margin call. However,
• If we do not withdraw the excess 2 on Mon, then balance on Tue = 6 - 3 = 3, which does not require margin call

(If i look at a recent GARP example, 2012 question 2, it is rendered moot with a scenario where the futures price only declines. This is one way to avoid the issue altogether, just show only futures price declines). Thanks,

 

[Steve Jobs]

Hi David and thanks to both of you guys, Shakti,

Since I don't have the practical experience, all I can do is to relay on the theory. So I categorized many practice questions into topics and sub-topics to search for pattern and look at the same issue from different angles. The exercise will reveal the undeclared/undocumented assumptions which are not mentioned explicitly...I went too far into audit...sorry! There is a company in Dubai which offers some training courses on the trading floor. I should go there one day.

So unless explicitly stated otherwise in the FRM exam question, I'll assume that the gain is taken out by the investor.

 

[David Harper CFA FRM]

Hi Steve, that's a great approach. I do reach a different conclusion: since there is a doubt, I would defer to Hull's assumption simply because it is given in the assigned reading (but I can understand a different conclusion, for sure). I will re-post back here if/when I hear back from GARP, I think they will find this interesting enough to weigh in ... thanks,

 

[Steve Jobs]

Thanks David, I'll be waiting for that.

 

[Steve Jobs]

There is a "Past FRM Exam Question" in Kaplan book 3 > End of the book Past FRM Exam Questions > Question No. 2 which assumes that the profit is not withdrawn. Is the solution in Kaplan book provided by GARP too or solved by Kaplan?

Unfortunately it was the only example I could find for this particular issue.

I think as David mentioned earlier , although Shakti's reasoning makes sense, we should assume the profit is not withdrawn.

 

[ShaktiRathore]

Hi steve,
Yes in the end it depends on the Q's assumptions , that is one of the two assumptions should be given,
i) the profit is not withdrawn
ii) the profit is withdrawn
please do check the above two assumptions whether thy are valid in the context of the Question given before proceeding with the Question's answer.

thanks

 

[Steve Jobs]

Hi Shakti,

It's not mentioned in the question whether the profit is withdrawn or not, thanks.

 

[ShaktiRathore]

you can always infer the above two assumptions from the question
you said

There is a "Past FRM Exam Question" in Kaplan book 3 > End of the book Past FRM Exam Questions > Question No. 2 which assumes that the profit is not withdrawn.

If you can infer the assumptions than its good to proceed.i mean it should be implicitely/explicitely mentioned in the question. But FRm sets a standard sets of questions which has similar assumtions that follows and if at all you get the one in the exam go by your thinking and the question.

thanks

 

[Steve Jobs]

Agreed, thanks Shakti,