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What is Initial and Maintenance Margin?

June 6, 2024June 13th, 2024No Comments

For UK businesses and individuals looking to hedge their currency exposure, understanding the concepts of initial margin, maintenance margin, and margin calls is crucial. These elements are essential when booking forward contracts to mitigate the risks associated with adverse currency movements.

Initial Margin

Initial Margin is the initial deposit required to book a forward contract. This deposit acts as collateral, protecting the broker from potential adverse currency movements during the duration of the contract.

  • Booking a Forward Contract: When you book a forward contract, you need to place a deposit in your account. This initial margin is a percentage of the total value of the forward contract. For example, if you are booking a forward contract with a notional value of £100,000 and the initial margin requirement is 5%, you will need to deposit £5,000.
  • Collateral Purpose: The primary purpose of the initial margin is to provide a security buffer that covers potential losses due to unfavorable currency movements, ensuring the broker is protected.
  • Special Cases: In certain situations, the initial margin can be as low as zero, depending on the relationship and credit profile of the individual or business booking the forward contract. A strong credit profile or a long-standing relationship with the broker can result in lower initial margin requirements.

Maintenance Margin

Maintenance Margin is the minimum amount of equity that must be maintained in your margin account to keep the forward contract open. It acts as a threshold to ensure that your position remains adequately collateralised.

  • Exchange Rate Fluctuations: If the exchange rate moves significantly against you, reducing the value of your initial margin to the point where it no longer covers potential losses, a maintenance margin requirement comes into play.
  • Margin Call: This situation triggers a margin call, requiring you to deposit additional funds to restore the margin to the required level. If the exchange rate moves 3% against your position, and your initial margin is no longer sufficient to cover the potential loss, you will need to top up your margin.

Margin Call and Risk of Contract Closure

A Margin Call occurs when the value of your margin account falls below the maintenance margin level. This necessitates immediate action to prevent the closure of your forward contract.

  • Top-Up Requirement: If you receive a margin call, you must deposit additional funds to meet the maintenance margin requirement. Failure to do so risks the broker closing out your forward contract to mitigate potential losses.
  • Outcome of Margin Maintenance: If you successfully meet the margin call by topping up your margin, your forward contract remains open. If not, the broker may liquidate your position to protect against further losses.

Settlement of Forward Contracts

At the end of the forward contract:

  • Return of Margin: The initial margin is either returned to you once you have settled the forward contract, provided there are no outstanding losses.
  • Final Balance Adjustment: Alternatively, the margin can be applied towards the final balance of the contract.

For UK businesses and individuals hedging their currency exposure, understanding initial margin, maintenance margin, and margin calls is vital. Booking a forward contract requires an initial margin deposit, serving as collateral against adverse currency movements. In some cases, this initial margin can be as low as zero, depending on your relationship and credit profile. However, there will always be a maintenance margin level, typically around 3%. This means if exchange rates move significantly against your position, a maintenance margin and potential margin call ensure that your account remains adequately funded to cover losses. Managing these margins effectively helps maintain your positions and mitigate the risk of having your forward contracts closed prematurely.

 

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