MTM (Mark-to-Market) and VaR (Value at Risk) Margins

1. Introduction to Margins in Trading

Stock exchanges implement margin requirements to mitigate risk, protect market stability, and ensure that traders can meet their financial obligations. Two key types of margins in trading are:

• Mark-to-Market (MTM) Margin: A daily settlement mechanism that adjusts traders' positions based on daily price changes.
• Value at Risk (VaR) Margin: A risk management tool that ensures traders maintain a minimum required amount of capital to cover potential losses.

2. Mark-to-Market (MTM) Margin

A. Meaning & Concept

• Definition: Mark-to-Market (MTM) is a daily settlement process where profits and losses on a trader's position are credited or debited to their account based on the change in the market price of the underlying asset.
• Daily Settlement: MTM ensures that gains and losses are settled on a daily basis, preventing the accumulation of large, unsettled losses that could lead to default.
• Additional Margin: If a trader incurs a loss, they must deposit additional margin funds into their account to cover the loss and maintain their position.
• Profit Credit: If a trader makes a profit, the corresponding amount is credited to their account.

B. MTM Margin Calculation (Numerical Example)

Scenario:

• An investor buys 100 shares of XYZ Ltd. at ₹500 per share.
• The exchange requires a 10% initial margin (not relevant to the MTM calculation itself, but to the initial setup).
• The stock price fluctuates over 3 days, as shown in the table below:

Explanation:

• Day 1: No price change, so there is no gain or loss.
• Day 2: The price drops to ₹480, resulting in a loss of ₹20 per share. The total loss is ₹20 * 100 shares = ₹2,000. The trader must deposit ₹2,000 into their account to cover the loss.
• Day 3: The price rises to ₹510, resulting in a profit of ₹30 per share. The total profit is ₹30 * 100 shares = ₹3,000. The trader receives ₹3,000 credited to their account.

3. Value at Risk (VaR) Margin

A. Meaning & Concept

• Definition: Value at Risk (VaR) Margin is a statistical measure used to estimate the potential loss in value of a portfolio or trading position over a specific time period and at a given confidence level.
• Capital Adequacy: VaR margin ensures that brokers maintain sufficient capital reserves to cover potential losses arising from adverse market movements.
• Historical Price Movements: SEBI and stock exchanges use historical price data and statistical models to calculate the potential worst-case loss that a security or portfolio could experience in 99% of trading days (or other specified confidence level).
• Volatility-Based: The VaR margin requirement is applied to stocks and derivatives based on their historical volatility, with more volatile assets requiring higher margin deposits.

B. VaR Margin Calculation (Numerical Example)

Scenario:

• Stock ABC Ltd. has a VaR of 12% based on its historical price movements.

• An investor wants to buy 200 shares of ABC Ltd. at ₹400 per share.

• Calculation:

  Required VaR Margin = VaR Percentage × (Number of Shares × Share Price)
  = 0.12 × (200 × ₹400)
  = 0.12 × ₹80,000
  = ₹9,600
  

Explanation:

• The trader must deposit ₹9,600 as VaR margin to initiate this trade. This margin is held by the broker to cover potential losses that may arise from fluctuations in the price of ABC Ltd.

4. Key Differences Between MTM and VaR Margins

Conclusion:

• MTM Margin ensures the daily settlement of profits and losses, reducing the risk of default and maintaining the financial integrity of the market.
• VaR Margin ensures that traders have sufficient collateral to cover potential market fluctuations, safeguarding brokers and the overall financial system from excessive risk-taking.
• Both MTM and VaR margins are critical risk management tools used by stock exchanges and brokers to promote stability and protect investors.