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FRM Part II · FRM Exam Part II · Future Value and Exposure

A dealer receives initial margin from a counterparty, segregated with a third-party custodian, in addition to daily variation margin. Compared with variation margin alone, what is the primary effect of the initial margin on the dealer's potential future exposure?

Initial margin acts as a buffer against price moves between the last variation margin exchange and close-out. Because it is sized to cover potential losses over the margin period of risk, it reduces the dealer's residual potential future exposure when the counterparty defaults.

  1. AIt covers potential adverse moves during the margin period of risk, reducing residual exposure at defaultCorrect
  2. BIt eliminates the need for close-out netting
  3. CIt increases the current mark-to-market of the portfolio
  4. DIt removes the dealer's exposure to the counterparty's rating changes in the future

Explanation

Variation margin tracks current mark-to-market, while initial margin is a buffer sized to cover potential losses in the margin period of risk. It therefore reduces potential future exposure at default. It does not replace netting or change mark-to-market.

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