Variation Margin

The initial contract price, and the daily price thereafter, is expressed as a rate on line. Hence a price of 20 means 20% of the contract limit/notional value.

A change in price will result in an immediate flow of Variation Margin between the parties. Such calculations are done twice daily (hence, 'marked to market').

When the contract price moves upwards (perhaps in response to an increasing hurricane threat), the Protection Seller will immediately pay the difference between the initial contract price and the daily price as Variation Margin to the Protection Buyer.

This means if the price moved from an initial contract price of 20 to 25, then the Protection Seller would immediately pay 5% of the contract limit/notional value to the Protection Buyer.

If the daily price then moved from 25 to 33, then a further 8% of the contract limit/notional value would immediately be payable by the Protection Seller to the Protection Buyer (and so on up to a maximum of 100% of the contract limit/notional value should an insured loss occur).

One could think of this as  the Protection Seller pre-funding a potential future claim.

If  the daily price moved downwards, the Protection Buyer will immediately pay Variation Margin to the Protection Seller.

This means if the daily price moves down from an initial contract price of 20 to 15, then the Protection Buyer would immediately pay 5% of the contract limit/notional value to the Protection Seller (and so on until the contract is settled at zero at the end of the contract risk period).

One could think of this as the Protection Buyer paying the ‘premium’ in instalments.

However, the daily price might initially rise above the initial contract price and then later fall below (and vice versa).  For example, the threat of a hurricane might increase steeply, and then recede or dissapate. 

In such a scenario,  the daily price may have first moved from 25 to 30, so the Protection Seller would immediately pay to the Protection Buyer 5% of the contract limit/notional value. Then, if the daily price fell back to 15 the Protection Buyer would immediately pay to the Protection Seller 15% of the contract limit/notional value (i.e. the difference between 30 and 15).

ELF prices trade strictly between 0 to 100.  This limits the potential financial obligation of the Protection Seller to the difference between the initial contract price and the contract limit/notional value, whilst limiting the potential financial obligation of the Protection Buyer to the initial contract price.

Download a practical example of Margin