Reference no: EM131582250

The Impact of Marking to Market and Margin Requirements on Futures Investments

Suppose an investor has a $1 million long position in T-bond futures. The investor's broker requires a maintenance margin of 4 percent, or $40,000 ($1m. times 0.04), which is the amount currently in the investor's account. Suppose also that the value of the futures contracts drops by $50,000 to $950,000. The investor will now be required to hold $38,000 ($950,000 times 0.04) in his account (or he has a $2,000 surplus). Further, because futures contracts are marked to market, the investor's broker will make a margin call to the investor requiring him to immediately send a check for $50,000 - $2,000, or $48,000, leaving him with an account balance of $38,000 at his broker for the $950,000 T-bond futures position.

If the next day the futures contract drops in value by another $40,000 to $910,000, the investor is now required to hold $36, 400 ($910,000 times 0.40) in his account. He has $1, 600 surplus ($38,000 - $36, 400). But, because futures contracts are marked to market, the investor's broker will make a margin call to the investor requiring him to immediately send a check for $40,000 - $1, 600, or $38, 400, leaving him with an account balance of $36, 400 at his broker for the $910,000 T-bond futures position.

If on day 3 the futures contract increases in value by $65,000, to $975,000, the investor is now required to hold $39,000 ($975,000 times 0.04) in his account. He has a $2, 600 deficit. Marking the account to market, to maintain the appropriate margin the investor may have his broker send him a check for $65,000 - $2, 600, or $62, 400, leaving him with an account balance of $39,000 at his broker for the $975,000 T-bond futures position.

As this example illustrates, the marking to market feature of futures contracts can lead to unexpected cash outflows as well as cash inflows for a futures investor.