Variation Margin is an amount of money that is either paid or received by one party to another as a result of changes in the value of a financial instrument. It is used in the context of over-the-counter (OTC) derivatives, such as futures and swaps. The purpose of variation margin is to ensure that the value of a financial instrument remains within certain limits, and to mitigate the risk of one party defaulting on the other.Variation margin is calculated based on the current market value of a financial instrument, and is used to offset any changes in the value of the instrument.For example, if the value of a derivative decreases, the party that holds the instrument would be required to pay the variation margin to the other party in order to maintain the agreed-upon collateral requirements.Conversely, if the value of the derivative increases, the party holding the instrument would receive a payment of the variation margin.An example of how variation margin works in practice is as follows: let's say two parties enter into a swap agreement, with one party agreeing to pay the other a fixed rate of return on a notional amount. If the market value of the swap decreases, the party that owes the fixed rate of return would be required to pay the variation margin to the other party in order to maintain the agreed-upon collateral requirements. If the market value of the swap increases, the party that owes the fixed rate of return would receive a payment of the variation margin.In summary, variation margin is an important tool in the management of risk in OTC derivatives, and is used to ensure that the value of a financial instrument remains within agreed-upon limits. The calculation of variation margin is based on the current market value of a financial instrument and is used to offset any changes in the value of the instrument.
