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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Let's think a little bit about how margin works for a futures contract. So let's say that the terms of the contract are a 1,000 pounds of apples for delivery on November 15, and we're assuming that this is some date in the future. And right now in the Futures Exchange, the market delivery price, so the price at which the apples will change hand in the future, is $200. And I've written here what the exchange specifies for the initial and maintenance margin, we'll talk about that more in a second. But this essentially means that both the buyer and the seller, for the initial margin, have to put up $20. Sometimes it'll be specified as an absolute dollar amount like I've just done. Sometimes it might be a percentage of the actual delivery price. So they both have to put up $20, and this guy has agreed to buy a 1,000 pounds of apples from this guy on November 15 for $200. So it's essentially $0.20 a pound. Now, let's say that a day goes by, and the next day-- these guys have this contract. This price right here is fixed in their minds. But let's say, the next day, the same contract between two other parties trades with the delivery price of $190. Now, all of a sudden this guy over here feels silly. He's like, man, I'm agreeing to buy something for $200 in the future which some other dude, all of a sudden, has agreed to buy for $190. This guy over here feels really smart. He agreed to sell something for $200 the day before, and now people are selling it for $190. So he's kind of $10 better than the people participating in the Futures Market today. The way market to market works with futures contracts is that the exchange says, well, you know what? I'm afraid that this guy, if things keep moving against him, he's not going to even want to put up the money to buy it at $200 if he can buy in the market at $190 or something lower. So I'm going to reset their futures contract to a delivery price of $190, but, to make things fair, this guy's going to be $10 in the hole. He's getting a $10 deal. If I take the delivery price from $200 to $190, I need to take $10 from this guy, because he's getting a $10 better deal. So from his margin account, I take it from $20 to $10. And then I place the $10 in this guy's margin account. If he's going to get $10 less of a good price on the delivery date, than let me give him the $10 right now. So his margin account will go to $30. Now, this number was 18, 17, 16, or 15, this guy wouldn't have to do anything. But right here, he's triggered his maintenance margin. Actually, he's right at our maintenance margin. So let's say that he goes-- that the next day, this happens a little bit more. It goes down to $185, and we have to do the process again. This guy loses $5, he goes down to $5, This guy will be given $5, so he goes to $35. In order for him to essentially reset the Futures Price, he's been given another $5. Now, this guy has only $5 in his margin account, and the maintenance margin is $10. So triggers a margin call, and this guy's got to find some place to put another $15 in his margin call. Every time you get below the maintenance margin, it triggers a margin call, and you have to refill your margin account to the initial margin. So he has to add $15, so he gets back to $20.