With Initial Margins ranging from $11-$30/Mt against Borrow Risks of up to $2.14/Mt, these Initial Margin rates greatly exceed the risk to a borrower and appear difficult to justify.
TAKING AN OPTION BASED, IMPLIED VOLATILITY APPROACH TO INITIAL MARGIN FOR OUTRIGHT POSITIONS
Outright LME positions tend to have more scope for movement and risk than calendar spreads, so you expect to attract a bigger IM. LME Initial Margin is calculated using historical price volatility and a 99% confidence interval, but how do these margin rates compare if options theory and market implied volatility is used to estimate the margin required for a 2 day price move at 99% confidence?
If you assume that the delta of an option is comparable to the probability of the market price reaching the strike price in a given time period, then the US$/Mt price gap between the strike price of a two day, 1% delta call option (priced basis current ATM volatility) and the underlying market would suggest the maximum upside price move with 99% confidence (i.e. 1% chance of that strike price being reached, so 99% chance of the price remaining below).
Using this option based method, the following table shows the price move at 99% confidence for trade day+1 through +8, compared to the current LME Initial Margin requirement for outright positions (left column, highlighted in blue):
Chart 3: US$/mt position loss to 99% Confidence basis LME implied vol% US$/MT POSITION LOSS TO 99% CONFIDENCE BASIS LME IMPLIED VOL%
LME IM Trade day plus 1 $120 $170 $494 $123
$1299 $188 $217
Source: ADMISI / LME Desk
AA AL CU NA NI
PB ZN
2 3 4 5 6 7 8
-$39 -$55 -$69 -$80 -$89 -$98 -$108 -$116 -$56 -$80 -$100 -$115 -$131 -$144 -$156 -$167 -$153 -$216 -$273 -$312 -$351 -$393 -$425 -$455 -$31 -$45 -$56 -$64 -$72 -$78 -$85 -$91 -$490 -$702 -$854 -$1001 -$1135 -$1253 -$1361 -$1462 -$64 -$90 -$112 -$131 -$148 -$163 -$176 -$189 -$83 -$118 -$146 -$171 -$193 -$213 -$231 -$247
18 | ADMISI - The Ghost In The Machine | September/October 2018
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