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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A dealer and a hedge fund have a bilateral OTC derivatives agreement with a daily-called variation margin. Which statement best describes the purpose of variation margin in this arrangement?

Variation margin transfers value between counterparties as the portfolio's mark-to-market changes, which keeps current exposure close to zero. Protection against losses that could arise during the close-out period is provided by initial margin, not variation margin.

  1. AIt covers potential future losses arising during the close-out period after a default
  2. BIt reflects the current mark-to-market exposure by transferring value as the portfolio value changesCorrect
  3. CIt is a fixed amount posted at inception that is never returned until maturity
  4. DIt is a fee paid to the counterparty for accepting credit risk

Explanation

Variation margin is exchanged to track changes in the current mark-to-market value of the portfolio, reducing current exposure. Covering potential future losses during the close-out period is the function of initial margin, so the first option describes the wrong type of margin.

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