FRM Exam Part II · Margin (Collateral) and Settlement

Initial Margin, Segregation and Rehypothecation Explained

Updated 11 October 2026 · Fact-checked

Initial margin is collateral posted upfront to cover potential losses on a defaulting counterparty's trades during the close-out period. It is sized with a VaR-style model, such as ISDA SIMM or a CCP model, at a high confidence level. Segregation protects posted collateral from the collector's insolvency. Rehypothecation lets the collector reuse it.

Understand Initial Margin, Segregation and Rehypothecation

Initial margin (IM) is a buffer. If your counterparty defaults, you must close out or replace its trades. Prices can move against you during that time. IM is collateral posted at the start, and topped up as risk changes, to cover that potential loss.

IM differs from variation margin (VM). VM moves with current mark-to-market value and removes current exposure. IM covers future exposure, that is, the move in value during the margin period of risk (MPOR). The MPOR is the time from the last margin call you received to the point the position is closed out and re-hedged. Under the BCBS-IOSCO uncleared margin rules, IM is calculated at a 99% one-tailed confidence level over a 10-day horizon, calibrated to a period of stress. The rules apply to covered entities above an average aggregate notional threshold, with a bilateral IM threshold of €50 million. IM is posted by both sides and is not netted between them.

Calculation has two common routes. A VaR-based approach (used by many CCPs, and by internal models) estimates the loss quantile of the netted portfolio, often from historical simulation. The ISDA SIMM is a standardized sensitivity-based model. Banks compute delta, vega and curvature sensitivities by risk class (interest rate, credit, equity, commodity, FX), apply risk weights, aggregate within buckets using correlations, then aggregate across risk classes. SIMM gives both sides the same number, which reduces disputes. The Basel schedule-based approach is a simpler alternative that gives larger, less risk-sensitive amounts, as it applies a percentage of notional by asset class and maturity.

Segregation means the posted IM is held by an independent third-party custodian, not by the collector. The rules require that IM collected is held in a way that protects the poster if the collector fails. The poster keeps ownership, so the assets are bankruptcy-remote. Rehypothecation means the collector re-uses the collateral, for example by pledging it to someone else. Under the uncleared margin rules, IM generally cannot be rehypothecated, with only narrow exceptions, and cannot be re-used. VM can be re-used.

The trade-off: segregation lowers the poster's credit risk but raises funding cost, since the poster cannot get use of the assets and the collector cannot reuse them. Rehypothecation cuts funding cost for the collector but creates chains of claims. If the collector fails, the poster may be an unsecured creditor for assets already passed on. This links to liquidity risk and procyclicality, as IM rises in stressed markets.

Key formulas to remember

Uncleared margin IM calibration: IM ≈ 99% one-tailed VaR over a 10-day horizon, stress-calibrated; BCBS-IOSCO standard for non-centrally cleared derivatives; netting is allowed only within a legally enforceable netting set.
Scaling VaR to a margin period: VaR(T days) = VaR(1 day) × √T; Valid under i.i.d. returns and normality; a rough approximation only. Example: √10 ≈ 3.162.
Parametric IM for a position: IM = z × σ(daily) × √T × Position value; z = 2.326 for 99% one-tailed under normality.
SIMM aggregation within a bucket: K = √( Σ WSᵢ² + ΣΣ(i≠j) ρᵢⱼ × WSᵢ × WSⱼ ); WS = risk weight × sensitivity; ρ = prescribed correlation. Results then aggregate across buckets and risk classes.
Net IM exposure to the poster: Loss to poster on collector default = IM posted − recovery of segregated IM; If segregated and bankruptcy-remote, recovery should be full; if not segregated or rehypothecated, the poster may be an unsecured creditor.

How to solve Initial Margin, Segregation and Rehypothecation questions

Use this order for any question on initial margin, segregation or rehypothecation.

1Identify whether the trade is cleared at a CCP, or uncleared and bilateral. This sets the rule set and the margin period of risk.
2Separate IM from VM. IM covers future potential loss; VM covers current mark-to-market.
3Find the calculation method asked for: SIMM, VaR-based, or schedule-based. Recall the calibration: 99%, 10 days, stress period for uncleared.
4If numbers are given, scale volatility to the horizon with √T, multiply by z and by exposure, and check the units.
5Check netting. IM is netted within one legally enforceable netting set, not across sets, and not between the two parties.
6For collateral questions, decide who holds the assets: segregated with a third-party custodian, or held by the collector.
7State the effect: who bears credit risk, funding cost, and liquidity strain, and whether rehypothecation is permitted.
8Check your answer against sense: stressed periods and longer MPOR raise IM; netting and diversification lower it.

Quickest way: Four-question shortcut

When to use it: Use when time is short and options differ in concept rather than arithmetic.

Ask: is it IM or VM? IM = future risk, VM = current value.
Ask: cleared or uncleared? Uncleared IM = 99%, 10-day, stress-calibrated, no rehypothecation in general.
Ask: who holds the collateral? Segregated means protected from collector insolvency; rehypothecated means the poster may become an unsecured creditor.
For arithmetic, compute z × σ × √T × exposure and eliminate options that are off by a factor of 10 or √10.

Common mistakes in Initial Margin, Segregation and Rehypothecation

Treating IM and VM as the same thing.
Both are collateral and both are called margin.
Fix: IM covers potential future loss over the MPOR; VM tracks current mark-to-market and is exchanged to remove current exposure.
Saying IM is netted between the two counterparties.
Students carry over the idea of netting exposures.
Fix: Under the uncleared rules, both parties post IM to each other on a gross basis. Netting applies only within a netting set to compute each side's amount.
Assuming rehypothecation is freely allowed for all collateral.
It is common in prime brokerage and repo.
Fix: Under the BCBS-IOSCO rules, IM collected for uncleared derivatives generally cannot be rehypothecated. VM can be reused.
Believing segregation removes all risk for the poster.
Segregation is linked with bankruptcy protection.
Fix: It removes the collector's insolvency risk on the assets, but the poster still faces custodian, legal, and operational risk, and funding cost rises.
Scaling 1-day VaR to 10 days by multiplying by 10.
Confusion between time-scaling of variance and of standard deviation.
Fix: Use √10 ≈ 3.162 under i.i.d. returns.
Thinking SIMM is a VaR simulation.
Both aim at a 99% 10-day loss.
Fix: SIMM is a sensitivity-based, formula model calibrated to stress, with prescribed risk weights and correlations; it is not a simulation run by each bank.

Worked examples

Example 1

A bank holds a single uncleared derivative position with a value of USD 50 million. The daily return volatility is 1.2%. Assuming normal returns, compute the 99% one-tailed, 10-day parametric IM. Use z = 2.326 and √10 = 3.162.

Show the solution

Daily loss volatility in USD: 1.2% × 50,000,000 = 600,000.
Scale to 10 days: 600,000 × 3.162 = 1,897,200.
Apply z: 1,897,200 × 2.326 = 4,412,887 (approx.).
Check: z × σ × √T × value = 2.326 × 0.012 × 3.162 × 50,000,000 ≈ 4.41 million.

Answer: About USD 4.41 million.

Example 2

Bank A posts USD 20 million of IM to Bank B on uncleared swaps. Bank B then fails. Compare the outcome for Bank A if the IM was (i) held with a third-party custodian in a segregated account, versus (ii) held by Bank B and rehypothecated to another party.

Show the solution

Case (i): the assets are held by an independent custodian and remain owned by Bank A, so they are bankruptcy-remote from Bank B. Bank A should recover them, less any amount B was entitled to for covering A's default losses (none here, since B defaulted).
Case (ii): the assets were reused by Bank B. Bank A holds a claim against B's estate for return of equivalent assets, not the original assets.
As an unsecured creditor, Bank A receives only a recovery fraction of the USD 20 million.
Conclusion: segregation protects the poster; rehypothecation exposes it to the collector's credit risk.

Answer: With segregation, Bank A expects to recover the full USD 20 million; with rehypothecation, Bank A is an unsecured creditor and may lose part of it.

Exam tips

Memorise the uncleared calibration: 99% one-tailed, 10-day horizon, stress-period data, and the bilateral gross posting with no rehypothecation of IM in general.
Questions on SIMM test concept: sensitivities, risk weights, correlations, and that both parties get the same number. Rarely will you compute a full SIMM.
For rehypothecation scenarios, ask who is the unsecured creditor after default. This usually decides the answer.
When asked about procyclicality, state that IM rises when volatility rises, which drains liquidity in stress.

Practice questions from Margin (Collateral) and Settlement

Initial Margin, Segregation and Rehypothecation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

FRM Part IMargining: Initial, Variation and Default Fund

Initial Margin, Segregation and Rehypothecation: frequently asked questions

What is SIMM in simple terms?

The ISDA Standard Initial Margin Model is a common formula that computes IM from trade sensitivities. Banks apply prescribed risk weights and correlations, so both sides can reach the same margin number and settle disputes quickly.

What is rehypothecation of collateral?

It is the re-use of collateral received from a client by the collector, for example pledging it as security for its own borrowing. It lowers funding costs but exposes the original poster to the collector's credit risk.

What is the difference between segregated and non-segregated initial margin?

Segregated IM is held by a third-party custodian and stays bankruptcy-remote from the collector. Non-segregated IM is held by the collector, so the poster may rank as an unsecured creditor if the collector fails.

How is initial margin calculated with a VaR-based approach?

You estimate the loss quantile of the netted portfolio over the margin period of risk, typically at 99% confidence, using historical simulation or a parametric model. The result is the margin required.