Capital efficiency of futures and IRS
There are three types of margin which IRS contracts require:
- matured cashflow margin: margin which covers the delta between the cashflows (so far)
- e.g.
- if the avg variable rate so far has been 5% and the fixed was 1%
- notional amt is $100
- time elapsed so far is 1 year
- the fixed rate receiver would need to have a margin at least as large as
- (5% - 1%) x $100 x 1 = $4
- Could just be paid out on the fly rather than being kept as margin
- e.g.
- contract NPV margin: margin which is equal to the NPV of the remainder of the contract
- e.g.
- if the “fixed market rate” for this contract is now 3%
- rather than the 1% it was when they initially agreed to it
- the contract expires in two years (so two years of cashflow payments left)
- notional amt is $100 as before
- if the “fixed market rate” for this contract is now 3%
- the fixed rate receiver would need to put up a contract NPV margin of (3% - 1%) x 2 years x $100 = $4
- so that if the fixed rate receiver defaulted, the variable rate receiver could take out another contract at the current market fixed IR of 3% and not have to incur any extra costs
- since the delta was covered by the margin
- so that if the fixed rate receiver defaulted, the variable rate receiver could take out another contract at the current market fixed IR of 3% and not have to incur any extra costs
- e.g.
- default exposure margin: margin which covers the exposure incurred by either party if the other defaults on them, before they find a new counterparty
- This I’d imagine would depend on some measure of expected volatility in the market fixed rate and also how long it is expected to take for the defaulted-on party to find a new counterparty
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