London SPAN for the LME Volume 2

Specification for Calculation of Discount Factors and Discounted Variation Margin

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LME SPAN Technical Specifications Volume 2

LC!"Clearnet

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Date #$%$&%&' $#%##%&' 'ersion #"$ #"# Author L Vosper L Vosper Summary of (hanges First (ssue Discount Factors) mathematical constant e specified to a minimum of * dps+ rounding of discount factors in e,ample to ' dps" 0pdated format

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Paul -ir./ood

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LME SPAN Technical Specifications Volume 2

LC!"Clearnet

'o$ume "
()NTENTS DOCUMENT HISTORY....................................................................................................1 1 CALCULATION OF DISCOUNT FACTORS................................................................1 2 DISCOUNT VARIATION MARGIN..............................................................................3 3 COMBINED CONTRACT VARIATION MARGIN.......................................................5 4 NET MARGIN..................................................................................................................6

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(AL(+LAT )N ), D S()+NT ,A(T)RS Discount factors are used for the calculation of for/ards 1ariation margin and in the production of for/ards 2is. Arra3s and Composite Deltas for initial margin"

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Annua$ised nterest Rates A term structure of annualised interest rates4 one for each currenc34 is recei1ed from the LME" These are interpolated%e,trapolated 53 LC!"Clearnet Ltd 6LC!7 to gi1e annualised interest rates 53 currenc3 for each calendar da3" The appropriate interest rate is then used as the 5asis for option pricing models ie a first 8ednesda39s rate for standard Traded :ptions and the rate corresponding to the maturit3 of the option for TAP:S" The3 are also used to deri1e the discount factors"

1.1.1 Continuously Compounded Annualised Interest Rates The annualised interest rates ha1e to 5e continuously compounded annualised rates to 5e consistent /ith the formulas for options pricing and for discount factors" Thus if 2ATE is the annualised rate and r is the continuousl3 compounded annualised rate4 then the natural logarithm of 6# ; 2ATE7 gi1es the 1alue for r) r < 1.1.2 ln 6 # ; 2ATE7

Discount Factors The continuousl3 compounded annualised interest rates are used to deri1e discount factors 6denoted df7 for each 5usiness date" For a gi1en 5usiness date /e ha1e df < #%6ert7 < e=rt /here r < continuousl3 compounded annualised interest rate t < time in 3ears from current close of 5usiness to the gi1en 5usiness date e < the mathematical constant used to a minimum of * dps E-amp$e Let r < $"$' close of 5usiness < #%2%#$ prompt date < #&%*%##

Then num5er of da3s from close of 5usiness is >'?4 and t < >'?%@'> < #">>@A2> (n this case4 df < e=6$"$'B#">>@A2>7

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< $"&##$$' The discount factor will be rounded to 6 decimal places.

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D S()+NT 'AR AT )N MARG N ,or.ard (ontracts The 1ariation margin for for/ard contracts measures the potential profit or loss for each for/ard contract at the latest close of 5usiness" For an LME contract this profit or loss is not immediatel3 realised 5ut 5ecomes due on the prompt date of the contract" (ts 1alue is therefore not its a5solute amount4 5ut the amount discounted 53 the interest return4 /hich /ould 5e made if the mone3 /ere immediatel3 a1aila5le" Thus for a contract 6e"g" CAD7 for/ards 1ariation margin for a gi1en trade for a gi1en prompt date is calculated as) VM < 6closing price = traded price7 , net position , tic. 1alue , lot siCe 8here prices are in tic.s" Tic. 1alue and lot siCe is defined in the SPAN parameter files" The 1ariation margin 1alues are rounded to the nearest 2 decimal places for all currencies e,cept Dapanese Een4 /hich are rounded to /hole num5ers" The 1alues at prompt date le1el are discounted to present 1alue 53 multipl3ing 53 the discount factor for that prompt date" (f for e,ample /e had @$ sold lots in Copper Dollars for the #&%*%## prompt date4 then the discount factor is $"&##$$' to ' decimal places as sho/n in the pre1ious section on discount factor calculation4 The discounted 1ariation margins for each of the prompt dates in the portfolio are summed alge5raicall3 6i"e" /ith regard to positi1e and negati1e signs7 to gi1e a single discounted for/ard 1ariation margin figure for that contract /hich could 5e positi1e or negati1e" Assuming prices as sho/n4 the discounted 1ariation margin for a short for/ards position is a de5it 1alue as latest closing prices ha1e gone up since the trade /as done i"e" since the traded price) F62A$$$$ = 22*#'@7 , =@$ , $"2> , #G , $"&##$$' < =H*$4*?'"*A to the nearest cent" The lot siCe is # and tic. 1alue is H$"2>" Prices are in tic.s" The negati1e sign denotes a de5it 1ariation margin as a loss has 5een calculated i"e" margin /ould 5e reIuired" Variation margins for other prompts /ould 5e /or.ed out in similar fashion4 and the o1erall discounted 1ariation margin /ould 5e the sum of these 1alues"

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2.1.1 Sign Convention Variation margin losses 6de5its7 are represented as negati1e num5ers and gains 6credits7 as positi1e" Note that SPAN sign con1ention is the opposite4 to 5e consistent /ith the operation of SPAN around the /orld i"e" 1alue losses are positi1e num5ers and gains are negati1e" "!" )ptions Variation margin for options contracts is N)T discounted4 as options are premium paid up front+ the 1ariation margin is 5ased on the 1alue of the option at the latest close of 5usiness" Thus for a gi1en contract 6e"g" CAD7 for an option on a gi1en prompt date4 option 1ariation margin < option closing price in tic.s , net position , tic. 1alue , lot siCe" The 1ariation margins for all options stri.es on a particular prompt date are summed alge5raicall3 to gi1e the options 1ariation margin for that prompt date" Note: TAP) /ariation margin This is calculated in the same /a3 as standard options4 the TAP: 1ariation margins for indi1idual stri.es 5eing summed for each TAP: maturit3 date" A negati1e results indicates a de5it 1ariation margin for for/ards or an3 class of option"

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()M1 NED ()NTRA(T 'AR AT )N MARG N The 1ariation margin for a com5ined contract is the alge5raic sum of all the 1ariation margins calculated for the com5ined contract" Thus the 1ariation margin for for/ards 65ased on discounting rules74 standard options and TAP:S for each contract 6e"g" CAD4 CAE4 CAE and CAS7 are summed after 5eing con1erted separatel3 to the Margin Currenc3 53 the da39s foreign e,change rates" Note that currenc3 shifts are not emplo3ed in 1ariation margin calculation" A single figure for the com5ined contract 1ariation margin is therefore calculated /hich is offset /ith initial margin as descri5ed 5elo/" Note that positi1e and negati1e 1ariation margins are added alge5raicall3 i"e" de5its and credits offset each other" (f the final result for a com5ined contract is a positi1e num5er4 then this represents a credit 1ariation margin" (f it is negati1e4 then the 1ariation margin is a de5it"

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NET MARG N Variation margin credits are offsetta5le against variation margin debits and initial margins for different LME com5ined contracts" This means that option credit 1ariation margin needs to 5e reduced 53 an amount calculated as initial margin to a1oid the granting of too large a credit i"e" similar to discounting collateral" The net margin for a single com5ined contract is the net of the com5ined contract9s 1ariation margin and initial margin4 in the margin currenc3 i"e" 0S Dollars" (n the sign con1ention used here4 negati1e 1ariation margins represent de5its i"e" losses and should 5e added to initial margins4 /hich are 53 definition al/a3s4 de5its" Positi1e 1ariation margins are credits and /ill offset initial margins" !ence a na.ed long call option /ill reIuire no co1er 5ecause the 1ariation margin /ill 5e a credit and /ill al/a3s 5e at least an eIual offsetting 1alue to the initial margin" These results for net margins are therefore eIui1alent to assigning a negati1e sign to a com5ined contractJs initial margin 6/hich is calculated in SPAN as a positi1e 1alue74 so that all de5its are denoted as negati1e4 and all credits are denoted as positi1e4 for the purpose of net margin calculation"

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