Understanding margins

This is part of a series that is building up over time, in gloriously random, unplanned fashion. We started with a post about understanding forward markets, then moved on to understanding leverage, then arbitrage. Today is about margins.

Imagine that you and your friends have decided to get together and throw a surprise birthday party for one of your friends. Now, birthday party implies cake. It’s the law, right?

And so you decide to go and book a cake, delivery three weeks from now (because that’s when the birthday is).

In the language of the financial markets, you’ve gone long on the forward contract for the cake, and the baker is the counterparty – she has gone short on the forward contract for the cake.

The baker says, well, ok, fine. The chocolate cake that you’re asking for will cost you a thousand bucks. And he asks that you pay, say, two hundred rupees now, and the rest on the day of delivery.

That is the basic idea behind margins. When applied to financial markets, the same principle is at work. If you have entered into a forward contract, you should pay part of the money up front. And the principle exists for the same reason in financial markets that it does in the market for chocolate cakes.

Boss, I don’t want to be left high and dry on the day of delivery. If you have paid me some money today, there’s a much higher chance that you’ll follow through on the deal. You now have, as they say, skin in the game.

So far, so simple, correct? Now let’s complicate the story a little bit.

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Imagine that, a week from now, the government announces that flour, eggs, vanilla, salt, sugar, baking powder and all dairy products are free, for everybody. Yes, this is an unrealistic assumption, but I’m an economist. We get to pull these stunts.

Is the baker going to be happy? Well, in general yes. Lower prices for her ingredients means that she will be able to produce cakes at much lower prices. Of course, if markets are efficient, this will also mean that the prices of cakes will fall. And therefore, in the specific case of the contract that you have with her, she is going to be less than happy.

Because she knows, as you do, that you can now get an equally good cake from another baker, at say, seven hundred rupees. The ingredients are free, after all! And she can do math as well as you can – so she realizes that it is in your interests to forget about the two hundred rupees that you paid her, and book a cake from another baker at seven hundred.

Total costs to you? Nine hundred: two hundred rupees that you paid her, plus seven hundred for the cake from the other guy. You’re still saving a hundred bucks!

And so she comes to you and says, hey listen. We have a deal, you and I. I think there’s a chance that you are going to back out of this deal, given these low prices for the ingredients. So I’m sorry, but I need you to pay me another two hundred rupees right now.

(By the way, if your response is “Aur nahi diya to kya?”, we enter the world of enforceable contracts, property rights and the law. But we won’t go down that path today.)

What the baker has done is she has MTM’ed your contract. Marked To Market.

That essentially means that every single day, the baker monitors the situation, and asks how much is the contract worth if it was deliverable today, and adjusts the initial deposit accordingly.

It cuts both ways, of course: if the price of the ingredients were to quadruple, you would go to the baker and not only ask for your initial deposit back… but also ask that the baker gives you money instead. Because now she has the incentive to back out of your original deal.

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There are rules about how margins work, and as usual, financial markets have their own little cottage industry of jargon around this. There’s the initial margin, the maintenance margin, margin calls and so on. But the point behind margins is very simple – you should have an incentive to not walk out of the deal, if things change in the market.

Financial markets, in other words, don’t take people at their word.

And on balance, that’s a good thing.

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Imagine if companies said to students on the day of the job offer that you keep one hundred thousand rupees with us, and we’ll give it back to you six months after you join us. Are you likelier to stop searching for better, more high-paying jobs?

Or if the placement cell said you need to keep ten thousand rupees on deposit with us, and only then can you sit for an interview. Would that stop the “I just wanted to see what the process was like, I didn’t actually want a job offer from this company” students from sitting for the placement process?

Neither of these things is going to happen, relax. But that, in essence, is the point of margins.