4-minute read
Nobody likes receiving a margin call, especially when it's a surprise. In this article we'll explain the basics of mark-to-market valuations, how collateral is used for currency hedges, and of course, margin calls...
Enter the Derivative
When a company enters a currency transaction to manage its foreign exchange risk, it takes a position in the underlying currency pair to offset losses induced by adverse movements in the exchange rate.
Example
- A UK boatbuilder has sold a yacht to a customer in Ireland for 1 million euros
- They expect to receive £870K on conversion, meaning an exchange rate of 1.1494
- The sale completes in 3-months, so they book a forward contract to sell €1m
- If the pound appreciates against the euro, from 1.15 to 1.20, the sale price of €1m would return £833k, but this is offset by the forward contract which is "in the money"
Mark to Market & Margin
Entering the forward contract to mitigate currency risk isn't where the story ends. The FX position changes in value over time – chiefly, as the spot rate moves – and, whilst this offsets the underlying transaction (the yacht sale), until the exchange of funds occurs, the hedge itself brings about a specific cash flow risk.
When a company enters a currency hedge, there's typically a need to hold cash collateral with the bank/broker. This is called the initial margin and it's usually equivalent to a small percentage of the total trade size, say 3%. Sometimes the initial margin is waived because a credit limit is provided to the firm by the bank/broker.
As the underlying exchange rate moves, the value of the position (the currency hedge) changes. A rule of thumb is that if the spot rate moves in what would be a favourable direction (spot is 'better' than the hedged rate), the hedge is worth less than at the time of booking – it's Out of the Money.
- In the Money (ITM): hedge is worth more than at the time of booking
- At the Money (ATM): hedge is worth the same than at the time of booking
- Out of the Money (OTM): hedge is worth less than at the time of booking
Here we see a Mark-to-Market chart for the €1m (EUR sell / GBP buy) forward contract that our example boatbuilder entered:
Margin Call
If the value of the open position moves negative, meaning it would cost more to exit the trade than the initial margin that is held (or greater than the credit limit), the company will need to increase the collateral balance by adding additional "variation" margin. This process is known as a margin call.
The process of monitoring open positions and producing the prevailing valuation is known as marking to market, and the position value should be provided online.
Want to know more?
Our philosophy at Oku Markets means no smoke and mirrors, and complete transparency with pricing and how markets operate.
We give live position value and collateral management via our online platform, so you can always manage your positions and there will never be any surprises!
You can contact us for a review of your currency processes and for our guidance and suggestions at [email protected] or 0203 838 0250.
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