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FRM Exam Part II · Margin (Collateral) and Settlement

Collateral and Margin Basics in OTC Derivatives

Updated 11 October 2026 · Fact-checked

Collateral is an asset one party posts to cover the other's exposure if it defaults. A credit support annex (CSA) sets the rules: threshold, minimum transfer amount, eligible assets and haircuts. To solve questions, compute exposure, subtract the threshold, apply the MTA test, then adjust for any collateral already held.

Understand Collateral and Margin Basics in OTC Derivatives

In an OTC derivative, one side usually owes the other a positive mark-to-market value. If the owing party defaults, the other side loses that value, less recovery. This is counterparty credit risk. Collateral reduces it. The party that owes value hands over assets, and the receiver can keep them if the payer defaults.

The terms live in the credit support annex (CSA), which sits under the ISDA Master Agreement. The CSA says who posts, when, how much, and in what form. Key terms are the threshold (exposure you accept unsecured), the minimum transfer amount (MTA) (the smallest call that triggers a transfer), the independent amount, eligible collateral and haircuts, and the valuation and call frequency.

Variation margin (VM) tracks the current mark-to-market. It moves daily as the portfolio value changes. Initial margin (IM) is an extra buffer against the loss that could arise between the last VM exchange and close-out, during the margin period of risk. IM is sized to a high-confidence potential move, not to current value.

Eligible collateral is usually cash in major currencies or high-quality government bonds. Non-cash collateral gets a haircut: its value is cut to allow for price moves and FX moves. Haircut value = market value × (1 − haircut).

Collateral does not remove risk. Residual risk remains from the threshold, the MTA, the gap between valuation and close-out, collateral price falls, and wrong-way risk when collateral is linked to the counterparty. Collateral also creates liquidity and operational risk for the poster.

Key formulas to remember

Credit support amount (one-way view)
Call = max(0, Exposure − Threshold − Collateral already held)
Exposure is the receiver's mark-to-market. Include any independent amount if the CSA requires it.
Minimum transfer amount test
Transfer only if |Call| ≥ MTA
If the call is below the MTA, nothing moves. Some CSAs round the transfer to a set unit.
Haircut collateral value
Collateral value = Market value × (1 − haircut)
Needed to find how much market value must be posted: Market value required = Value needed ÷ (1 − haircut).
Uncollateralised exposure left
Residual ≈ Threshold + MTA gap + price change over margin period of risk
A rule of thumb for what stays unsecured, not an exact formula.

How to solve Collateral and Margin Basics in OTC Derivatives questions

Use this order for any numerical or conceptual collateral question.

  1. 1Identify who is owed value. Only the party with positive mark-to-market can call for collateral.
  2. 2Write down the CSA terms: threshold, MTA, independent amount, rounding, haircuts and collateral already held.
  3. 3Compute the required collateral: exposure minus threshold, plus any independent amount.
  4. 4Subtract collateral already held, after applying haircuts to its value.
  5. 5Compare the call to the MTA. If it is smaller, no transfer happens.
  6. 6If non-cash collateral is used, gross up the market value needed by dividing by (1 − haircut).
  7. 7State the residual unsecured exposure and the risks left, such as the threshold and margin period of risk.
  8. 8Check whether the question is about VM or IM and match your reasoning to that.

Quickest way: Threshold, MTA, then haircut

When to use it: Use for numerical call-amount questions under time pressure.

  1. Compute exposure − threshold − collateral held.
  2. If the result is below the MTA, answer zero transfer.
  3. If a haircut applies, divide the needed value by (1 − haircut).
  4. Eliminate options that ignore the threshold or the MTA.

Common mistakes in Collateral and Margin Basics in OTC Derivatives

  • Treating the threshold as a deductible that is paid only once

    Students confuse it with an insurance deductible.

    Fix: The threshold is the exposure left unsecured at all times. The call is exposure minus threshold, every time.

  • Applying the MTA to the exposure instead of the call

    The MTA sounds like a floor on exposure.

    Fix: Compute the call first. The MTA is tested against the call amount.

  • Multiplying by (1 − haircut) when sizing the posting

    Students apply the haircut in the wrong direction.

    Fix: To deliver a required value, divide by (1 − haircut). Multiply only when valuing collateral already held.

  • Mixing up initial and variation margin

    Both are called margin.

    Fix: VM tracks current mark-to-market and moves daily. IM covers potential future moves over the margin period of risk.

  • Saying collateral eliminates counterparty risk

    Students overstate the benefit.

    Fix: Residual risk remains from the threshold, MTA, valuation delays, collateral price moves and wrong-way risk.

Worked examples

Example 1

A bank has a mark-to-market exposure of USD 12 million to a counterparty. The CSA has a threshold of USD 3 million and an MTA of USD 0.5 million. The bank already holds USD 8 million of cash collateral. How much must the counterparty post now?

Show the solution
  1. Required collateral = 12 − 3 = USD 9 million.
  2. Collateral held = USD 8 million.
  3. Call = 9 − 8 = USD 1 million.
  4. Compare with MTA: 1 ≥ 0.5, so the transfer is triggered.

Answer: The counterparty must post USD 1 million.

Example 2

Exposure is EUR 6 million, threshold is EUR 2 million, MTA is EUR 1 million, and no collateral is held. The counterparty posts government bonds with a 5% haircut. What market value of bonds must it deliver?

Show the solution
  1. Required value = 6 − 2 = EUR 4 million.
  2. Call 4 million is above the MTA of 1 million, so a transfer is due.
  3. Market value needed = 4 ÷ (1 − 0.05) = 4 ÷ 0.95.
  4. 4 ÷ 0.95 = EUR 4.21 million, approximately.

Answer: About EUR 4.21 million market value of bonds, which is worth EUR 4 million after the haircut.

Exam tips

  • Always list threshold, MTA and haircut before calculating. Questions often hide one of them in the text.
  • Watch the direction of the haircut. Divide to size a posting, multiply to value holdings.
  • For concept questions, link IM to the margin period of risk and VM to current mark-to-market.
  • Expect interpretation questions on residual risk. Name the threshold, MTA, gaps in timing and wrong-way risk.

Practice questions from Margin (Collateral) and Settlement

Collateral and Margin Basics in OTC Derivatives: frequently asked questions

What is a credit support annex (CSA)?

A CSA is a legal document under the ISDA Master Agreement that sets collateral rules between two OTC derivative counterparties. It covers thresholds, minimum transfer amounts, eligible collateral, haircuts and call timing.

What is the difference between initial margin and variation margin?

Variation margin follows the current mark-to-market of the trades and is exchanged regularly. Initial margin is an extra buffer sized for potential losses over the margin period of risk after a default.

What do threshold and minimum transfer amount mean?

The threshold is the exposure level you accept unsecured before collateral is required. The minimum transfer amount is the smallest call that triggers a transfer, which avoids frequent tiny movements.

Why is collateral still risky?

Collateral can lose value, be hard to sell or be correlated with the counterparty. Delays between valuation, call and close-out also leave exposure uncovered.