From the course: Derivatives Fundamentals

Understanding futures contract margins

From the course: Derivatives Fundamentals

Start my 1-month free trial Buy for my team

Understanding futures contract margins

“

- [Instructor] A major difference between forwards and futures is that futures contracts are settled daily. A counterparty's margin account is credited or debited as the spot price of the underlying asset changes. If, for example, the margin account of the buyer or seller falls below a certain point, known as the minimum required margin or secondary margin, a margin call will happen. The counterparty is required to then deposit more money into the margin account to retain their position. And we'll work through an example so you know exactly how margin accounts work in practice. We're going to calculate together the margin requirements for the following contract. We're going to assume we're looking at an oil futures contract that's going to be delivered three days from now. The futures price in the contract is $50 per barrel, and the contract size is 1,000 barrels. Now, at the bottom of the screen, you'll see that we're actually going to be trading 10 contracts, so in fact, 10,000 barrels. But each contract is for 1,000 barrels. The tick size is 1 cent, which means that the price of oil on this futures contract will move in increments of 1 cent. However, because we're always trading in increments of 1,000 barrels, a change of 1 cent per barrel actually translates to a change of $10 per contract. Because this is a commodity future, the delivery will be physical. We'll actually physically deliver the oil. Now, we want to focus on the margins. There are two margins listed here, an initial margin and a maintenance margin, sometimes referred to as a secondary margin. So what do these really mean? So I'm going to use a bank account analogy first before we move on and do some detailed calculations. So if you want to think about a bank account, the initial margin would be the amount that the bank says you have to deposit just to open a new account. In this case for the futures contract then, what we're saying is to open the futures contract, the counterparties have to deposit $5,000 each per contract with the exchange. So, because there are 10 contracts, each counterparty needs to deposit with the exchange $50,000. The maintenance margin here is $3,000. You can think of a maintenance margin like the minimum balance you need to keep in a bank account. So, in our scenario, we are saying, to open the future's contract, you need to deposit $5,000 per contract with the exchange. However, you also need to make sure that the minimum balance in the margin account with the exchange never drops below 3,000. If the margin account does drop below 3,000, the counterparty will be asked for a margin call. Let's look at this now in more detail.

Contents