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Risk-based Margining for OTC Forex Options: Introduction
Copyright 2008 FX BridgeTechnologies Corp.
U.S. Provisional Patent Application - Serial No.: 61/038,171
Title: VOLATILITY-BASED MARGINING
Recent developments in the design and availability of new financial products have prompted financial institutions and the organizations that regulate them to reexamine methods of evaluating financial risk. In order for these products and the institutions that offer them to remain competitive in the global marketplace, there must be in place a safe and efficient system of determining capital requirements for firms and customers.
The Commodity Futures Modernization Act of 2000 (CFMA) amended the Commodity Exchange Act (Act) to clarify the Act’s application to “off-exchange” or over-the-counter (OTC) foreign exchange (forex) transactions. Under the Act, regulated Futures Commission Merchants (FCMs) may be counter-party to OTC forex futures and options transactions.(1)
National Futures Association (NFA) Financial Requirements Section 12 states the security deposit (margin) requirements for retail customer accounts. While these requirements provide a safe and reasonable security level for individual transactions, their use on a portfolio of option positions can result in security deposit requirements much higher than necessary. The use of a risk-based margining method would allow for security deposit levels that protect both the retail customer and the FCM, while affording the retail customer the full leverage that these instruments allow.
This same methodology can be utilized to compute FCM capital requirements for acting as counter-party to these transactions. Similar methods have been used for many years with regard to exchange-traded and other off-exchange instruments.(2)
Current Security Deposit Requirements
From the NFA bylaws Financial Requirements Section:(3) (7012] SECTION 12. SECURITY DEPOSITS FOR FOREX TRANSACTIONSWITH FOREX DEALER MEMBERS. [Adopted Effective December 1, 2003.]
Each Forex Dealer Member shall collect and maintain the following minimum security deposit for each foreign currency futures and options transaction between the Forex Dealer Member and a person that is not an eligible contract participant as defined in Section 1a(12) of the Act and that are not executed on a contract market, a derivatives transaction execution facility, a national securities exchange registered pursuant to Section 6(a) of the Securities Exchange Act of 1934, or a foreign board of trade:
(i) 2% of the notional value of transactions in the British pound, the Swiss franc, the Canadian dollar, the Japanese yen, the Euro, the Australian dollar, the New Zealand dollar, the Swedish krona, the Norwegian krone,and the Danish krone;
(ii) 4% of the notional value of other transactions;
(iii) for short options, the above amount plus the premium received; and
(iv) for long options, the entire premium.
The Executive Committee may temporarily increase these requirements under extraordinary market conditions.
Risk-based Margining
All domestic and many worldwide futures exchanges use a risk-based margining system for calculating security deposit requirements.(4) This system, Standard Portfolio Analysis of Risk (SPAN®), was developed by the Chicago Mercantile Exchange (CME).(5)
SPAN® has successfully been used for margining foreign currency futures at the CME (and for many other markets and at other exchanges) since 1988. Although developed for futures and options trading, the overall objective and methodology used in SPAN® margining can be used as a model for a risk-based margining system for OTC forex transactions.
Overall Objective
The objective behind risk-based margining is to determine the largest reasonable one-day loss that a portfolio of options might experience.(6) This is done by using industry-standard option pricing models (7),(8) to value the profit and loss of the portfolio under various market scenarios.
There are two parameter values needed to perform
a risk-based margin calculation:
• Underlying Range
• Volatility Range
For exchange-traded instruments, the Underlying Range is typically set to the initial or maintenance margin requirement for a futures transaction. The Volatility Range is set according to current market conditions of the respective contracts. At least once daily, the various exchanges set these input parameters for margining their own instruments.
There is no central exchange for OTC forex option transactions to set and distribute the input parameters necessary to perform risk-based margin calculations. Conservative parameters for forex markets can be inferred, however, from current NFA security deposit requirements. Furthermore, if stated and used as percentages of notional value, these parameters do not need to be adjusted
Underlying Range
The current NFA security deposit requirement for a forex transaction is 2% (9) of notional value. Similarly, performance bond requirements for the CME currency futures contracts are also approximately 2% (10) of contract value.
These security deposit levels are set with the assumption that in most trading sessions, market price movement will not exceed these ranges. Thus, these values can be used as reasonable Underlying Ranges.
Assuming that a 2% or more one-day price change in the underlying market represents a three standard deviation (3s) event, this should occur, at most, once every 370 trading sessions.(11) This implies that the underlying market has a one-day price change distribution with a standard deviation of approximately 0.67%.(12)
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Figure 1 shows a normal (“bell-shaped”)
one-day price change distribution with a 0.67% standard deviation (13)
Figure 1: Implication of a 2% Security Deposit
Volatility Range
A one-day price change distribution with a standard deviation of 0.67% implies an annual price change distribution with a standard deviation (volatility) of approximately (14) 10.5%.(15) Thus, using 10.5% volatility as an input parameter is consistent with the current security deposit requirement of 2% of notional value.(16)
Conservative values for the volatility range are necessary to assess the risk associated with extreme price movements. In addition, these values cannot be changed daily to respond to market conditions, as is the case with SPAN parameters that are set and distributed by the exchanges.
An adequate lower value for the volatility
range is 0.0%. Using 0.0% in the option calculations has the effect of
valuing all options at their intrinsic value. For long option positions,
this valuation results in a margin level of 100% of premium paid, which
matches the current security deposit requirement (iv). In addition, for
simple option spreads, using 0.0% volatility results in margin requirements
equal to the maximum loss that the spread can experience. This is consistent
with “position-based” margining rules, which were the standard
before SPAN was introduced.
An adequate upper value for the volatility range is 21.0%.(17)
In addition to the intuitive notion of using twice the baseline volatility of 10.5%, the 52-week historical volatility for the major currencies has remained below 21.0% since January of 2000. (18)
Although a range of 0.0% to 21.0% volatility might seem overly conservative, the examples below show that, in some cases, risk-based margining using these parameter values performs significantly better than (and never worse than) using the current security deposit requirements.
Margin Charge Calculations
Risk-based margining methods make use of two calculations:
• Risk Assessment Charge
• Short Option Minimum Charge
Total margin charge is the greater of these two numbers
Risk Assessment Charge
Borrowing from the SPAN methodology, option portfolios can be analyzed
at each of 16 market scenarios:
Scenarios 15 and 16 are included to assess the risk of far out-of-the-money short options that would not fall within the maximum one-day price change. Because of the unlikely event of these options becoming in-the-money, the risk margin associated with these two scenarios are only charged at 35%.
The Risk Assessment Charge for the portfolio of options is the greatest loss seen across the 16 scenarios
Short Option Minimum Charge
Even with the conservative values for Underlying Range and Volatility Range outlined above, deep out-of-the-money short options may not produce any significant risk charges when evaluating the 16 risk scenarios. To be consistent with other risk-based margining methods in use worldwide, any method for OTC Forex options should contain a Short Option Minimum Charge.(19) This is simply a risk charge of 0.05 % of notional value for each short option in the portfolio.
Summary
Under the Commodity Futures Modernization Act of 2000, regulated Futures Commission Merchants may act as counter-party to “off-exchange” (over-the-counter) foreign exchange futures and options transactions. National Futures Association security deposit requirements for these transactions are currently higher than necessary, hindering the ability of these products and the institutions that offer them to remain competitive in the global marketplace. The use of a risk-based margining method would result in security deposit levels that both protect financial integrity and afford a more efficient use of capital for the retail customer. This same methodology can be utilized to determine capital requirements for the FCM.
The objective behind risk-based margining is to determine the largest reasonable one-day loss that a portfolio of options might experience. There are two parameter values needed to perform a risk-based margin calculation: Underlying Range and Volatility Range. There is no central exchange for OTC forex option transactions to daily set and distribute the input parameters necessary to perform risk-based margin calculations.
Conservative parameters for forex market transactions can be inferred, however, from current NFA security deposit requirements. When expressed as a percentage of notional value, these parameters do not have to be adjusted, providing for a maintenance free methodology for efficient risk-based margining.
Example 1: Long Call
Example 2: Short Call
Example 3: Call Spread
Example 4: Call Back Spread
Example 5: Short Straddle
Example 6: Complex
(1) National Futures Association, Retail Forex Transactions;
A Regulatory Guide, www.nfa.futures.org/compliance/publications/forexRegGuide.pdf
(2) US Government Accounting Office, RISK-BASED CAPITAL: Regulatory and
Industry Approaches to Capital and Risk, www.gao.gov/archive/1998/gg98153.pdf
(3) National Futures Association, NFA Manual / Rules, www.nfa.futures.org/nfaManual/bylaws.asp
(4) National Futures Association, Margins Handbook, NFA Joint Audit Committee,
1999 www.nfa.futures.org/compliance/publications/Margins/MarginsHandbook.pdf
(5) Chicago Mercantile Exchange, CME Standard Portfolio Analysis of Risk
(SPAN) www.cme.com/clr/rmspan/rmspan/intro1155.html (6) Ibid., www.cme.com/clr/rmspan/rmspan/intro1155.html#2
(7) Black, Fischer and Scholes, Myron “The Pricing of Options and
Corporate Liabilities” Journal of Political Economy Vol. 81, No.3
May/June 1973;pp.637-654
(8) Garman, Mark B. and Kohlhagen, Steven W. “Foreign Currency and
Option Values” Journal of International Money and Finance December
1983;pp.231-237
(9) 4% for some currency pairs.
(10) 4% for the same currency pairs.
(11) The probability of a 3s or greater event for a normal distribution
is 0.27%; 1/.0027 = 370.4
(12) 2% Range / 3s = 0.666…%. For those currency pairs with a security
deposit of 4%, we can similarly assume a one-day price move distribution
with a standard deviation of 1.333…%. (4% Range / 3s = 1.333…%)
(13) Price change distributions are usually assumed to be lognormal. For
a one-day price change, however, the
difference between normal and lognormal distribution assumptions is minimal.
(14) Natenberg, Sheldon, Option Volatility and Pricing Strategies: Advanced
Trading Techniques for
Professionals, 1st ed. (Chicago: Probus, 1988), 344.
(15) Assuming 252 trading sessions in a year, annualized volatility =
(2% / 3) * v252 = 10.58%.
(16) For those currency pairs with a security deposit of 4%, annualized
volatility = (4% / 3) * v252 = 21.17%.
(17) For those currency pairs with a security deposit of 4%, upper volatility
range value would be 42.0%.
(18) See the Appendix. The period cited begins 52 weeks after the introduction
of the Euro.
(19) Chicago Mercantile Exchange, Components of SPAN: Chicago Mercantile
Exchange www.cme.com/clr/rmspan/compont2480.html#4
for Forex, CFDs, and Options.
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