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Initial margin vs variation margin
Two collateral flows sit under every derivatives relationship, and they answer two different questions about a counterparty default.
Variation margin (VM) covers the loss that has already happened.A derivative's value moves every day; whoever is on the losing side owes the mark-to-market change, and VM is the daily — increasingly intraday — cash settlement of it. If your swap moved $2M in my favor today, you post $2M tonight. In credit-risk terms, VM keeps the current exposurepinned near zero: if you default tomorrow, everything up to today was already settled. It flows both ways over the trade's life, it's typically cash the receiver owns outright (reusable), and under a CSA the operative dials are the threshold and the minimum transfer amount — regulatory VM sets the threshold to zero.
Initial margin (IM) covers the loss that hasn't happened yet.VM has a blind spot: default is not instantaneous. Between the counterparty's last VM payment and the day you've actually closed out or replaced their portfolio, the market keeps moving — and nobody is settling those moves anymore. That window is the margin period of risk (MPOR): conventionally 10 days for uncleared bilateral trades, ~5 for cleared, shorter for exchange products. IM is a buffer sized to the potential adverse move over that window, at high confidence (usually 99%).
Three properties follow from IM's job, and each contrasts with VM:
- Both parties post it gross — each posts to the other, and the amounts don't net.
- It must be segregated at a third-party custodian, not reusable — its whole point is to survive the poster's bankruptcy.
- It's funded capital locked up for the trade's life, and that funding cost is MVA in the XVA family.
For uncleared OTC under the Uncleared Margin Rules, the industry-standard IM model is ISDA SIMM; CCPs run their own models (SPAN and its VaR-based successors). Every methodology in this track is, at bottom, a way of computing IM.
🎛 Default-timeline simulator
A $10M swap: VM settles daily — until the counterparty defaults on day 40
Blue: MtM settled daily by VM (credit exposure ≈ 0). Purple band: the MPOR — nobody is paying VM anymore. The path segment turns red when the unsettled move breaks through the amber IM ceiling.
Biggest daily VM call
$473,470
Move over MPOR
$158,096
IM held
$984,605
Uncovered residual
$0
VM settles the past: every move up to the default was paid in cash, so pre-default P&L causes no credit loss. IM pre-funds the close-out window: it must absorb whatever the market does between the last VM payment and the day you're flat. At 2.33σ the ceiling holds ~99% of the time — resample until you find the path that breaks it. What's left past the ceiling is counterparty credit risk proper: CVA, capital, add-ons. Educational tool — not investment advice.
The clean mental model
Walk the default timeline in three steps:
- Up to the last margin call — losses covered by VM (current exposure ≈ 0).
- From the last call to close-out (the MPOR) — losses covered by IM.
- Beyond what IM covered — the tail past the confidence level plus liquidation friction: this residual is what CVA, capital and the add-ons exist for.
VM settles the past, IM pre-funds the close-out window, and everything past IM is counterparty credit risk proper.
The subtlety: VM converts risk, it doesn't erase it
Receiving VM eliminates your credit exposure by creating a liquidity demand on the payer. A large VM call is a cash call — and margin spirals kill leveraged counterparties precisely this way: positions move, calls go out, the client sells assets to raise cash, the selling moves the market further, the next call is bigger. The failed-fund case studies all share this shape: the VM calls were correct, and the counterparty died of them anyway. Note the “biggest daily VM call” figure in the lab — that's the number a client treasurer actually fears.
Things to try
- • Resample a few times at 2.33σ — most paths stay under the IM ceiling, but roughly one in a hundred close-out moves breaks through. That's exactly what 99% coverage means.
- • Stretch the MPOR from 2 to 10 days: IM grows with √t, and the residual risk grows with it. This is why cleared trades (short MPOR) need less IM than bilateral ones.
- • Double the vol and note both IM and the biggest VM call scale together — riskier markets squeeze the client from both sides.
Test yourself
Why is IM posted gross and segregated while VM nets and is freely reusable? (Follow each flow through the poster's bankruptcy: VM is a settlement of value already owed — netting it is the point; IM is a performance bond against future moves — if the receiver could reuse it, it would vanish in exactly the default that makes it necessary.)