Understanding the SPAN Methodology

Leveraged Trading and Margins

One of the reasons why traders are attracted to derivatives trading is the leverage that derivatives contracts provide. Leveraged trading uses a smaller amount of funds or capital to gain exposure to a larger position in an underlying asset. Leverage, when prudently applied, can significantly enhance returns. The primary enabler of leverage is the margining system that derivatives exchanges adopt.

In derivatives trading, you must deposit funds with your futures broker before you can initiate a trade. The clearing house determines the amount of funds or margin you are required to put up for each futures or options contract. Margin or performance bond requirements are financial safeguards and risk management measures to enable the clearing house to mitigate default risk in the market. In Malaysia, the clearing house is Bursa Malaysia Derivatives Clearing, which sets the margin requirement for all listed derivatives contracts traded on Bursa Malaysia Derivatives Exchange.

In this article, we will delve into the methodology of how Bursa Malaysia Clearing House calculates the margin requirements for market participants' open positions.

SPAN (Standard Portfolio Analysis of Risk) Margining

Bursa Malaysia Derivatives Clearing uses the SPAN margining system to calculate the performance bond requirements. The SPAN margining system is a portfolio risk-based methodology developed by the Chicago Mercantile Exchange (CME) that looks into the overall risk exposure of a portfolio and combines both futures and option positions. SPAN looks at the risk of the entire portfolio instead of focusing on each position separately. With this methodology, the clearing house can calculate a more precise margin requirement that reflects the actual risk. For example, if you hold both long and short positions in the same asset, SPAN will recognize that the risks are offset and thus require a lower margin than holding each position individually.

The foundation of SPAN's margin calculation is based on risk scenarios called SPAN risk arrays. SPAN risk arrays simulate potential underlying price movements and calculate the profit and loss on individual contracts. The system also organizes all the related futures and option positions of the same underlying assets so that margin credits of one contract can offset margin liabilities in another contract.

SPAN generates multiple hypothetical scenarios to understand how much a portfolio could lose under different conditions, such as potential underlying price movements, volatility, and the impact of time to expiry on option value.

SPAN Risk Arrays and Scanning Risk

The clearing house uses a set of 16 scenarios or risk arrays, a table of pre-calculated risk values for a particular contract. Risk arrays will represent how much the contract will lose or gain by scanning through the 16 simulated market conditions.

Each scenario results in a potential loss or gain, and SPAN uses these results to determine the worst-case loss for the portfolio. The scenario resulting in the largest loss or worst-case scenario is the Scanning Risk. The margin requirement is set primarily on the scanning risk number since this will ensure enough funds are available to cover potential losses even in extreme market conditions.

For example, if SPAN simulates what happens if the market moves significantly up or down, and the worst-case scenario shows a potential loss of RM8,000 for the portfolio, then the clearing house will require the position to have a minimum margin of RM8,000.

How SPAN Handles Intra-Commodity and Inter-Commodity Spreads

The methodology considers the relationship between different contracts in related futures and options contracts since those contracts may offset each other's risk. The calculation is called spread margining, which results in margin credits used to lower the overall margin requirement.

The two types of spreads below qualify for margin credits that reduce the margin requirements:

1. Intra-Commodity Spreads: These are positions within the same commodity but with different contract months (e.g., long Crude Palm Oil Futures (FCPO) futures in December and short FCPO futures in March).

2. Inter-Commodity Spreads: These are positions in different but related commodities, such as Crude Palm Oil Futures (FCPO) and USD RBDPalm Olein Futures (FPOL). These markets often move together, reducing the margins required.

Evaluating Options Risk

SPAN handles both futures and options positions in a portfolio.For options, it will assess how the option's value changes under different price and volatility scenarios. SPAN incorporates these changes into the overall risk calculation for the portfolio. For example, if you have a short option position, the methodology will calculate how much you could lose if the market moves against you and factor that into the margin.

Physical Delivery Risk

The SPAN methodology also accounts for risks arising from spot months or contracts nearing expiration where physical delivery is involved. The clearing house applies an add on charge for this increased risk called Spot/ Delivery Month Charge.

Take an example if the scanning risk for FCPO spot month is RM8,000 and the spot month charge is RM300. Then, the SPAN margin requirement for this portfolio is RM8,300.

How It Works - Example of SPAN In Action

Consider if you hold the following positions:

• Long 1 FCPO Contract (December Month)

• Short 1 FCPO Contract (January Month)

• Short 2 Call Options on FCPO

The SPAN system will go through the following process to determine the margin required for your portfolio above.

1. SPAN generates various scenarios for movements in the price and volatility of Crude Palm Oil

2. Calculates the gains and losses under each scenario.

3. Identifies the worst-case scenario loss, say RM9,000

4. Applies the spread credits from your long and short FCPO positions

5. Determines the options risk and add to the futures margins

6. Arrives at the total margin requirement, say RM7,000

In summary, SPAN margining benefits both traders and the clearing house by providing a more accurate reflection of the actual risk of a portfolio. Traders typically benefit from lower margin requirements than traditional margining systems, which do not consider related positions or product offsets.

The methodology makes the margin calculation more efficient by considering multiple risk factors and scenarios and being flexible enough to adapt to different market conditions and products.