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Let’s learn about risk management and margining. Margining risk is a financial risk that future cash flows are smaller than expected due to the payment of margins, i.e. collateral as a deposit from a counterparty to cover some (or all) of its credit risk. It can be seen as short-term liquidity risk, a quantity called MaR can be used to measure it.
Margin, in simple terms, is an exchange introduced risk management procedure. Let us understand the concept in detail through a simple example.
An investor has a bullish view on the market and purchases 2,000 shares of ‘ABC’ company at Rs100 on March 05, 2018. To complete the transaction, he/she has to make a payment of Rs2,00,000 (2,000×100) to his broker on or before March 06, 2018. The broker, in turn, has to provide this money to the respective stock exchange through which the transaction occurred by March 07, 2018. In this situation, there is always a risk that the investor may not be in a position to oblige the trade by the required date. Risk management and margining is an important aspect of commodity traders.
In order to deal with this issue, the broker collects an upfront token amount from the client. The stock exchange then collects a similar amount from the broker upon execution of the order. This initial amount that was collected is known as ‘margin’.
Margin amount is collected for both the buyer and the seller of the shares in order to make sure that both parties oblige to the contract. It is collected from the seller to ensure that he delivers the shares sold, while it is collected from the buyer so that he brings the money and is serious about the transaction.
