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, macro-economic 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, wherein 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 per share on 3 June. The stock attracts a 10% margin.
Mr A is required to pay 10% of Rs 35,000 on 3 June even though the transaction concludes on 5 June. 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 XYZ has a VaR of 7%, then under normal trading conditions, XYZ will not lose more than 7% 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. In the above example, if the price of XYZ falls to Rs 325 when the market closes on 3 June, Mr A will lose Rs 2,500. He will have to pay this amount before the start of trading on 4 June.
