How does variation margin work mechanically, and how does it differ from initial margin in terms of purpose and daily operations?

Variation margin (VM) is the daily exchange of collateral that reflects changes in the mark-to-market value of a derivatives portfolio. Unlike initial margin (which covers potential future exposure), VM settles the realized gains and losses that have already occurred, effectively converting the derivative into a daily-settled instrument.\n\nVM vs. IM: Different Purposes:\n\n| Feature | Variation Margin | Initial Margin |\n|---|---|---|\n| Purpose | Settle realized P&L | Cover future potential losses |\n| Calculation basis | Current MTM change | Potential exposure over MPOR |\n| Direction | Flows to the party with gains | Posted by both parties |\n| Frequency | Daily (sometimes intraday) | Recalculated periodically |\n| Asset form | Cash only (post-2017 rules) | Cash or eligible securities |\n| Segregation | Not segregated (belongs to receiver) | Must be segregated |\n| Rehypothecation | Permitted (it's a settlement) | Prohibited |\n\nDaily VM Process:\n\n`mermaid\ngraph TD\n A[\"T: Valuation time
(usually end of business)\"] --> B[\"Calculate net MTM
of all trades under CSA\"]\n B --> C[\"Compare to previous
day's net MTM\"]\n C --> D[\"VM call amount =
Today's MTM - Yesterday's MTM
- Current collateral held\"]\n D --> E{\"VM amount >
Threshold + MTA?\"}\n E -->|Yes| F[\"Issue VM call
by notification deadline\"]\n E -->|No| G[\"No call — change
below operational minimum\"]\n F --> H[\"Counterparty delivers
collateral by T+1\"]\n H --> I[\"Reconcile and confirm
receipt of collateral\"]\n`\n\nWorked Example:\nPeakstone Capital and Elsworth Bank have the following CSA terms:\n- Threshold: $0 (full collateralization)\n- MTA: $250,000\n- Eligible VM collateral: USD cash only\n\nDay 1: Portfolio MTM = +$3.2 million (Elsworth owes Peakstone)\n- VM call: $3.2 million\n- Elsworth transfers $3.2 million cash to Peakstone\n\nDay 2: Portfolio MTM = +$2.8 million (MTM declined by $400K)\n- Required collateral: $2.8 million\n- Currently held: $3.2 million\n- VM return: Peakstone returns $400,000 to Elsworth\n\nDay 3: Portfolio MTM = +$3.0 million (MTM increased by $200K)\n- Additional collateral needed: $200,000\n- $200K < $250K MTA, so no margin call is triggered\n- Residual unsecured exposure: $200,000\n\nDay 4: Portfolio MTM = +$3.6 million (MTM increased by $600K from Day 2 level)\n- Cumulative under-collateralization: $3.6M - $2.8M (held) = $800K\n- $800K > $250K MTA, so margin call for $800,000\n\nDispute Resolution:\n\nIf Elsworth calculates the MTM as +$2.9 million while Peakstone calculates +$3.6 million on Day 4:\n- The undisputed amount ($2.9M) is transferred immediately\n- The disputed portion ($700K) enters a resolution process\n- Most CSAs require transfer of the agreed-upon amount within the notification deadline\n- Disputes are typically resolved within 2-3 business days using independent pricing sources\n\nPost-2017 Rules (Phase 1-6 UMR):\n\nSince March 2017, mandatory VM rules require:\n- Daily VM exchange for all OTC derivatives between covered entities\n- VM must be in cash for single-currency swaps (no bonds)\n- Zero threshold is the regulatory standard (contractual thresholds may still apply for uncovered entities)\n\nPractice margin calculations in our FRM Part II question bank.