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From Wikipedia

In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty (most often their broker or an exchange). This risk can arise if the holder has done any of the following:

  • borrowed cash from the counterparty to buy financial instruments,
  • sold financial instruments short, or
  • entered into a derivative contract.

I can understand the purpose of collateral in the first two cases, but don't in the third one "entered into a derivative contract".

So I wonder why there is collateral in this third case? What is the purpose of collateral?

Thanks and regards!

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-1/vote to close as offtopic. cf. also ongoing discussion at meta: meta.money.stackexchange.com/questions/510/… –  fennec Jun 6 '12 at 16:54
3  
@fennec Individual investors may certainly enter into a derivative contract. Writing a covered call option comes to mind as one strategy often used to generate income from a stock position. I don't think this question is off-topic. –  Chris W. Rea Jun 6 '12 at 16:58

3 Answers 3

up vote 8 down vote accepted

A derivative contract can be an option, and you can take a short (sell) position , much the same way you would in a stock. When BUYING options you risk only the money you put in. However when selling naked(you don't have the securities or cash to cover all potential losses) options, you are borrowing. Brokers force you to maintain a required amount of cash called, a maintenance requirement.

When selling naked calls - theoretically you are able to lose an INFINITE amount of money, so in order to sell this type of options you have to maintain a certain level of cash in your account. If you fail to maintain this level you will enter into whats often referred to as a "margin-call". And yes they will call your phone and tell you :).

Your broker has the right to liquidate your positions in order to meet requirements.

PS: From experience my broker has never liquidated any of my holdings, but then again I've never been in a margin call for longer then a few days and never with a severe amount.

The margin requirement for investors is regulated and brokers follow these regulations.

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Hmm. +1 - you got it right. Why are we recapping on Meta? –  JoeTaxpayer Jun 22 '12 at 3:45

The most obvious use of a collateral is as a risk buffer. Just as when you borrow money to buy a house and the bank uses the house as a collateral, so when people borrow money to loan financial instruments (or as is more accurate, gain leverage) the lender keeps a percentage of that (or an equivalent instrument) as a collateral. In the event that the borrower falls short of margin requirements, brokers (in most cases) have the right to sell that collateral and mitigate the risk.

Derivatives contracts, like any other financial instrument, come with their risks. And depending on their nature they may sometimes be much more riskier than their underlying instruments. For example, while a common stock's main risk comes from the movements in its price (which may itself result from many other macro/micro-economic factors), an option in that common stock faces risks from those factors plus the volatility of the stock's price.

To cover this risk, lenders apply much higher haircuts when lending against these derivatives. In many cases, depending upon the notional exposure of the derivative, that actual dollar amount of the collateral may be more than the face value or the market value of the derivatives contract. Usually, this collateral is deposited not as the derivatives contract itself but rather as the underlying financial instrument (an equity in case of an option, a bond in case of a CDS, and so on). This allows the lender to offset the risk by executing a trade on that collateral itself.

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Derivatives derive their value from underlying assets. This is expressed by the obligation of at least one counterparty to trade with the other counterparty in the future. These can take on as many combinations as one can dream up as it is a matter of contract.

For futures, where two parties are obligated to trade at a specific price at a specific date in the future (one buyer, one seller), if you "short" a future, you have entered into a contract to sell the underlying at the time specified. If the price of the future moves against you (goes up), you will have to sell at a loss. The bigger the move, the greater the loss. You go ahead and pay this as well as a little extra to be sure that you satisfy what you owe due to the future. This satisfaction is called margin.

If there weren't margin, people could take huge losses on their derivative bets, not pay, and disrupt the markets. Making sure that the money that will trade is already there makes the markets run smoothly.

It's the same for shorting stocks where you borrow the stock, sell it, and wait. You have to leave the money with the broker as well as deposit a little extra to be sure you can make good if the market moves to a large degree against you.

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