Variation margin in presence of trade cash flows

A couple of years ago, I have posted a blog called Continuous dividend v cash flows.

With the generalisation of Variation Margin (VM) collateral, the derivative world is not driven anymore by discrete cash flows but by continuous dividend. Due to practical constraints, the VM is paid with a one day delay. This delay reduces significantly the effectiveness of the margin process as credit risk exposure reduction mechanism around the trade cash flow payments. The above blog presented an efficient and simple approach to bring back the effectiveness of the VM process even around trade flows dates. The approach is based on the usage of a forward valuation in the VM computation process.

Since then, the research related to the spike of counterparty exposure has earned to its authors the Quant of the Year award. In the award winning paper (Does initial margin eliminate counterparty risk?), the authors have introduced my proposal in one of the conclusion paragraph.

In its Guide on assessment methodology for the IMM and A-CVA, the ECB has also put as special emphasise (Part 4, Chapter 7, 43.(3).(e)-(g)) on looking at this issue.

As the issue is gaining more attention, I though it would be useful to republish the blog, with minor updates, as a working paper. The document can now be found on SSRN: Variation margin in presence of trade cash flows.

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