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UNDERSTANDING MARGINS
Frequently asked questions on margins
As applicable for transactions in
Derivatives Segment of Pakistan Stock Exchange
Introduction
The Management of Pakistan Stock Exchange considers that the investors' confidence in the fair dealings
at the Exchange is the key to rapid development of the market. Therefore, its goal is to ensure effective
risk management in secondary market trading and to protect investors' interest.
In accordance with their commitment towards enhancing investor protection and providing greater
transparency, PSX have striven to bring out this information brochure regarding the margins.
Investors may kindly note that the said publication is not a substitute for the relevant regulations and
requirements which are specified by the Exchange from time to time. Therefore investors are advised to
refer to the relevant provisions of the PSX regarding the margins before transacting business with the
TREC holders.
Frequently Asked Questions on Risk Management
1. Why should there be margins?
Every day of life we face uncertainties either it’s about our health, sudden incidence like natural
disasters, weather and country’s economic conditions, etc. And to overcome these crises we take
certain remedies to minimize its consequences. So same happens in the stock markets, there is
uncertainty in the movement of share prices.
This uncertainty leads settlement, which create hindrances for investors to invest in stock market,
and
this is sought to be addressed by margining systems.
Example:
ABC COMPANY
Purchased shares
500
Purchased Price
Rs:100/Purchased amount Rs:50000/-
Suppose an investor, purchases 500 shares of ABC company at Rs.100/- on March 21, 2016 Investor
has to give the purchase amount of Rs.5,0000/- (500 x 100) to his broker on or before March 22,
2016. Broker, in turn, has to give this money to PSX on March 23, 2016.
There is possibility that the investor may not be able to bring the required money by required date
for buying shares. As an advance investor is required to pay a 5% of the purchased amount to the
broker at the time of placing the buy order. Stock exchange in turn collects similar amount from the
broker upon execution of the order. This initial payment is called Pre-trade margin.
Margin is applicable for both buyer as well as seller. Margin payments ensure that each investor is
serious about buying or selling shares. Prices of shares may keep on moving every day. Margins
ensure that buyers bring money and sellers bring shares to complete their obligations even though
the prices have moved up or down.
2. What is volatility?
Volatility is the degree of variation of a trading price series over time as measured by the standard
deviation of returns. Volatility in prices has a significant impact on investor’s decision regarding
buying and selling shares.
3. How is volatility computed? Can you give an example?
Volatility is computed by standard deviation that can easily be done through Microsoft excel, let us
compute volatility based on close prices of a share over last 15 days. We can also called it “historical
volatility” as it is computed on historical data.
Method:
First of all, we need to enlist last 15 days share prices in a column of the excel sheet. Then we need
to calculate the daily returns that can be calculated by using ‘LN’ (natural log) function in excel. Use
the formula LN (today’s close price / yesterday’s close price) in the next column for calculating daily
returns for all the days. Go to the end of the second column (after the last value) and use the excel
function ‘STDEV’ (available under statistical formulas) to calculate the Standard Deviation of returns
computed as above. The calculated standard deviation expressed as percentage is the ‘historical
volatility’ of the share for the 15 days period. Statistical formulae of volatility is illustrated in
Appendix-i.
Volatility of Engro foods is calculated below in excel sheet by taking 15 days share prices from 1st
February 2016 to 15 February 2016.
Date
1-Feb-16
2-Feb-16
3-Feb-16
4-Feb-16
5-Feb-16
6-Feb-16
7-Feb-16
8-Feb-16
9-Feb-16
10-Feb-16
11-Feb-16
12-Feb-16
13-Feb-16
14-Feb-16
15-Feb-16
VOLATILITY
Closing price of
Engro Foods
151.95
152
152.5
150
150.95
153
149.98
151
151.9
154
155
155.8
154
153.5
151.02
%Change Engro
Foods
0.03%
0.33%
-1.64%
0.63%
1.36%
-1.97%
0.68%
0.60%
1.38%
0.65%
0.52%
-1.16%
-0.32%
-1.62%
1.12%
4. What is the difference between price movements and volatility?
Prices of shares fluctuate depending on the future prospects of the company. We hear of stock
prices going up or down in the markets every day. Popularly, a share is said to be volatile if the
prices move by large percentages up and/or down. A stock with very little movement in its price
would have lower volatility.
Let us compute volatility of two companies Engro foods and Oil and Gas Development Company
(OGDC) to see how daily price movements of these companies affect the computed historical
volatility.
Date
1-Feb-16
2-Feb-16
3-Feb-16
4-Feb-16
5-Feb-16
6-Feb-16
7-Feb-16
8-Feb-16
9-Feb-16
10-Feb-16
11-Feb-16
12-Feb-16
13-Feb-16
14-Feb-16
15-Feb-16
VOLATILITY
Closing price of
Engro Foods
151.95
152
152.5
150
150.95
153
149.98
151
151.9
154
155
155.8
154
153.5
151.02
%Change
Engro Foods
0.03%
0.33%
-1.64%
0.63%
1.36%
-1.97%
0.68%
0.60%
1.38%
0.65%
0.52%
-1.16%
-0.32%
-1.62%
1.12%
Closing price
of OGDCL
116
116.02
116.9
117.1
117.9
116.43
116
116.9
117.2
118.02
118.9
119.2
119.9
120
119.6
%Change
OGDCL
0.017%
0.758%
0.171%
0.683%
-1.247%
-0.369%
0.776%
0.257%
0.700%
0.746%
0.252%
0.587%
0.083%
-0.333%
0.577%
As you can see from the above, prices of shares of Engro company moved up and down throughout
the period and the price changes were ranging from 1.36% to -1.97%. The calculated historical
volatility is 1.12% for the period. Shares of company OGDCL moved up and down but with smaller
percentage variations ranging from 0.683% to -0.369% here historical volatility is 0.577% and is the
least volatile share of the two shares. Higher volatility means the price of the security may change
dramatically over a short time period in either direction. Lower volatility means that a security’s
value may not change as dramatically.
5. Is volatility linked to the direction of price movements?
Volatility is not directly linked with the direction of price movement, prices may move up or may
move down and Volatility will capture only the scope of the fluctuations in the stock prices.
6. How does change in volatility affect margins?
Share price depends on the market performance of the company and market performance vary
from time to time for every company and ultimately variation in share price occurs on daily basis,
sometimes it goes up and sometimes it goes down.
As in above example illustrated in question 4, we considered share price movements of 2 companies
Engro and OGDCL during the period February 1, 2016 to February 15, 2016. On the morning of
February 16, 2016, no one knows what would be the closing price of these 2 shares. However,
historical volatility number would tell you that shares of “Engro “may move up or down by large
percentage whereas shares of “OGDCL” may see a small percentage variation compared to close
price on February 15, 2016. This is only an estimate based on past price movements. Since the
uncertainty of price movements is very high for “Engro” its shares would attract higher initial margin
whereas shares of ‘OGDCL’ should attract lower initial margin since its volatility is low.
7. Are margins same across Ready and derivatives Markets?
Shares traded on regular market are settled in two days whereas derivative contracts may have
longer time to expiry. Derivative market margins have to address the uncertainty over a longer
period.
Therefore, SECP has prescribed different way to margin cash and margins of both Regular, CSF and
DFC are based on VaR.
8. What are the types of margins levied in the Ready market segment?
Margins in the ready market segment comprise of the following three types:
1) Exposure margins
2) MtM losses
3) Liquidity margins
9. What is Value at Risk (VaR) margin?
Value at risk (VaR) is a statistical technique used to measure and quantify the level of financial risk
(maximum expected loss) within a firm or investment portfolio over a specific time frame on a
certain level of confident which is determined by the Risk Meter.
10. How is VaR margin calculated?
VaR margin will be based on Risk Meter calculation using the following three methods:
(i) Percentile Variance/ Covariance,
(ii) Variance/ Standard normal VaR
(iii) Exponentially Weighted Moving Averages (EWMA)
The highest VaR margin calculated under the above three methods is taken as the VaR or Raw VaR
The Raw VaR is then scaled up by a factor of √n to cover an ‘n’ day risk based on the underlying
scrip’s liquidity as demonstrated by its categorization on the basis of trading frequency and impact
cost as mentioned in given table 1. Based on the respective categorization, the Raw VaR numbers
for each scrip are then scaled up by a factor of √1, √3 and √5 respectively. For securities falling in the
D category, maximum VaR i.e., 60% shall be applied. The number so arrived shall be called as Scaled
up VaR.
TABLE 1:
SCALE
UP
CATEGORY FACTOR
A
B
√3
C
illiquid - D
NO. OF DAYS COUNT (BASED ON
AVAILABILITY OF RS.500,000 TRADE
DATA)
≥ 80% of traded days
≥ 80% of traded days
≥ 80% of traded days
√5
< 80% of traded days
If the tradable days even with one (1) lot in a a scrip is
less than 33%
IMPACT COST
≤ 1%
> 1% ≤ 2%
> 2%
Irrespective of
IC
(Detailed note on impact cost is available in Appendix- ii).
11. How is the Worst Case Margin computed?
A Worst Case Margin is added to the Scaled up VaR to cover 1% of the days (extreme events) that go
beyond those envisaged on the 99% value at risk estimates used in the calculation of Raw VaR the
margin so arrived shall be known as the VaR Estimate.
The Worst Case Margin is the higher of:



5%
1.5 times the standard deviation of daily returns of the stock price in the preceding six
months or one year (whichever is higher) and
Maximum breach in the security’s VaR back tested over one year trading days (peaks over
threshold)
12. How is Mark-to-Market (MTM) margin computed?
MtM Loss (or Profit) shall be calculated on trade to trade basis, separately for each scrip, for each
client and for proprietary open positions of a Broker on the basis of the last executed prices during
trading hours on a trading day. In our example in question number 1, we have seen that a buyer
purchased 500 shares @ Rs.100/- on March 22, 2016. If close price of the shares on that day
happens to be Rs.85/-, then the buyer faces a notional loss of Rs.7500/. On his buy position. In
technical terms this loss is called as MtM loss and is payable by March 22, 2016 (that is same day of
the trade).
In case, on a given day, buy and sell quantity in a share are equal, that is net quantity position is
zero, but there could still be a notional loss / gain (due to difference between the buy and sell
values), such notional loss also is considered for calculating the MTM payable.
MTM Profit/Loss = [(Total Buy Qty X Close price) - Total Buy Value] - [Total Sale Value - (Total Sale
Qty X Close price)]
13. Where can I find information of applicable VaR margins?
PSX: Rule Book
14. What are the types of margins levied in the Futures Segment?
FUTURE EXPOSURE MTM
MARKET MARGIN
LOSSES
SPECIAL
MARGIN
Not
Applicable Applicable
Not
Applicable Applicable
Applicable Applicable
CONCENTRATION
MARGIN
CSF
Applicable
Applicable
DFC
SIFC
Applicable
Applicable
Applicable
Not Applicable
15. How is Pre-Trade Margin Computed?
Pre-trade margins are payable at the time of entering the order and are charged @ 5% of order
value (notional value).
Example:
KSE-30 Index
Spot Price
Quantity
Rs:1000
500
Notional Value
Rs:500,000
Pre-trade Margin
Rs:25,000
Pre-trade margin is calculated as 5% of notional value (500,000x0.05=25000).
16. How is exposure margin computed?
 The Exposure margins for each security in Ready and Deliverable Futures Contracts markets shall
be calculated by the Exchange applying VaR Estimates calculated by the Risk Meter at the end of
each trading day.
 The Exposure margins for each Security in Cash-Settled Futures Contract Market shall be
calculated by the Exchange applying Scaled-up VaR calculated by the Risk Meter at the end of
each trading day.
 The Exposure margins in Stock Index Options and Stock Index Futures Markets shall be
calculated by the Exchange applying VaR of the underlying index calculated by the Risk Meter at
the end of each trading day and adding Worst Case Margin.
 The Exposure margins so determined shall be posted on website of the Exchange and shall be
applicable for determining margin requirement at the end of each trading day.
17. Do I get margin benefit if I have a positions in different underlying?
No, according to netting rules, no margin benefit will be provided in different underlying positions.
18. Do I get margin benefit if I have position in both futures and options in same underlying?
No, both are different market having different netting rule.
19. Do I get margin benefit if I have counter positions in different months in same underlying?
No, because settlement period is different. But in case of calendar spread positions margin benefit is
provided by charging margins on higher position.
Appendix-i
Volatility
Volatility is calculated as the annualized standard deviation of daily change in price.
The statistical formulae for volatility is:
Standard deviation is a measure of the spread of data; the degree to which observations differ from the
mean.
If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the
price almost never changes, it has low volatility. A volatile market experiences unpredictable price
fluctuations.
Let us take an example to understand volatility or standard deviation. The stock returns of the company
A for past five years are 15%, 25%, 18%, 40%, 35% .What is the standard deviation of the returns of
Engro Foods?
x̅ =
√15 + 25 + 18 + 40 + 35
5
Mean of returns = 26.6
σ =
√(15 − 20)2 + (25 − 20)2 + (18 − 20)2 + (40 − 20)2 + (35 − 20)2
5
σ = √92.24
σ = 9.604%
Appendix-ii
Impact cost
Introduction
Liquidity in the context of stock markets means a market where large orders can be executed without
incurring a high transaction cost. The transaction cost referred here is not the fixed costs typically
incurred like brokerage, transaction charges, depository charges etc. but is the cost attributable to lack
of market liquidity as explained subsequently. Liquidity comes from the buyers and sellers in the market,
who are constantly on the lookout for buying and selling opportunities. Lack of liquidity translates into a
high overhead cost for buyers and sellers. Liquidity means transactions cost; a highly liquid market is one
where large transactions can be immediately done without incurring much transactions cost.
Impact cost is the most practical and realistic measure of market liquidity; it is closer to the true cost of
execution faced by a user as compared with other methods of price estimation.
When the entire limit order book is observed, impact cost can be calculated at any desired transaction
size.
Definition:
“Impact Cost” (IC) represents the amount of adverse price movement in fulfilling an order size of Rs.500,
000/- or any other amount as prescribed by the Exchange with the prior approval of the Commission,
during the last six months. The IC is calculated on a real time basis and is adjusted for every change in
the order book due to an order size of Rs.500,000/- or any other amount prescribed in the above
manner.
Application of Impact Cost:
The Impact Cost is one of the identifying parameters for scaling up Raw VaR values before being added
to WCM to calculate final VaR values of the scrip. The matrix below illustrates how Impact Cost is being
used to determine scale up factors in computation of in-house PSX VaR values:
SCALE
UP
CATEGORY FACTOR
A
B
√3
C
illiquid - D
NO. OF DAYS COUNT (BASED ON
AVAILABILITY OF RS.500,000 TRADE
DATA)
≥ 80% of traded days
≥ 80% of traded days
≥ 80% of traded days
√5
< 80% of traded days
If the tradable days even with one (1) lot in a a scrip is
less than 33%
IMPACT COST
≤ 1%
> 1% ≤ 2%
> 2%
Irrespective of
IC
Calculation of Impact Cost
Given below are the steps to calculate impact cost on an order size of RS 500,000/=
SAMPLE ORDER BOOK
S#
Buy Side Order Book
Sell Side Order Book
Qty
Price
Qty
Price
01
5000
35.95
10000
36.00
02
10000
35.90
15000
36.05
03
5000
35.85
5000
36.10
1. calculate the ideal cost, which is average of best bid and best ask price
a. Ideal price = (Best Buy Price + Best Sell Price)/ 2
b. Ideal Price = (35.95+36.00)/2 = 35.97
2. calculate average execution price for order(s) worth 500,000/=
S#
01
02
Volume
Price
10000
36.00
3883.50
36.05
Average Execution Price
Value
360,000
140,000
36.01
Average Execution Price of an equity—against a value of RS 500,000/= using sell side order
book. i.e. (10,000 X 36 + 3883.50 X 36.05) / 13883.50
𝐼𝑚𝑝𝑎𝑐𝑡 𝐶𝑜𝑠𝑡 = (
IC
=
𝐸𝑥𝑒𝑐𝑢𝑡𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 − 𝐼𝑑𝑒𝑎𝑙 𝑃𝑟𝑖𝑐𝑒
) × 100
𝐼𝑑𝑒𝑎𝑙 𝑃𝑟𝑖𝑐𝑒
((36.01-35.97)/35.97) X 100
=
0.11%, this buyers impact cost against a purchase of a security worth 500,000/=
means you incurred a cost of 0.11% while buying 13883.50 shares because of liquidity
conditions in that stock. Similarly Impact Cost for seller side (using buy order book) can be
calculated.
For any queries please contact:
Product Development Department,
Pakistan Stock Exchange Limited
(Formerly Karachi Stock Exchange Limited)
Email: [email protected]
UAN: 111-001-122