Stock trading is open to several types of risks and calculating these is an integral part of market analysis. While most crucial risks are related to the market, macroeconomic factors and corporate performance, there exists another type called the counterparty risk. It stems from the possibility of a participant not honouring a commitment. However, it is not considered in market risk analysis because stock exchanges cover it adequately by imposing margins.
A margin is a fixed percentage of the value of transaction to be paid at the time of placing the buy order. Indian equity markets use the 'T+2 day' settlement system under which trades initiated on day T are settled on day T+2, with margins payable on day T. Consider Mr A, who agrees to purchase 100 shares of XYZ at Rs 350 apiece on June 3. The stock attracts a 10 per cent margin. Mr A is required to pay 10 per cent, or Rs 3,500, on June 3 even though the transaction concludes on June 5.
There are three types of margins applicable in equity markets: the value at risk (VaR) margin, the extreme loss margin and the mark to market (MTM) margin. The margin payable upfront is the sum of VaR and extreme loss margins. Let us consider these in detail: VaR Margin: It gives an estimate of the maximum loss that can occur in a day.
For example, if a stock has a VaR of 7 per cent, then under normal trading conditions, it will not lose more than 7 per cent of its price till the next day. VaR has two main determinants: volatility and liquidity. While volatility is measured using standard deviation, liquidity is gauged via impact cost. VaR margin tends to be high for stocks that are volatile and have low liquidity.
Extreme Loss Margin: It covers losses that are beyond the scope of VaR margin. It provides an additional layer of security and the exchanges calculate it at the beginning of each month. This margin is determined by volatility and value of the transaction. Margin rates are available on the BSE and NSE websites. The sum of VaR and extreme loss margins gives an idea of the stock's variability. The higher the stock's unpredictability, the higher the margin.
MTM Margin: It is calculated at the end of the day, considering the difference between the market price and transaction price of the stock. It is collected before the start of trading on day T+1. MTM covers the risk of default due to change in stock prices.
Courtesy: Money Today