228 CHAPTER 6. THE MARKET FOR CURRENCY FUTURES
theory every gain or loss is immediately settled in cash, but this may mean frequent,
small payments which is costly and inconvenient. So in practice losses are allowed to
accumulate to certain levels before amargin call(a request for payment) is issued.
These small losses are simply deducted from the initial margin until a lower bound,
the maintenance margin, is reached. At this stage, a margin call is issued, requesting
the investor to bring the margin back up to the initial level.
Example 6.7
The initial margin on agbp62,500 contract may beusd3,000, and the mainte-
nance marginusd2,400. The initialusd3,000 margin is the initialequityin your
account. The buyer’s equity increases (decreases) when prices rise (fall), that is,
when marking-to-market gains or losses are credited or debited to your account. As
long as the investor’s losses do not sum to more thanusd600 (that is, as long as
the investor’s equity does not fall below the maintenance margin,usd2,400), no
margin call will be issued to her. If her equity, however, falls belowusd2,400, she
must immediately addvariation marginto restore her equity tousd3,000.
Failure to make the margin payment is interpreted as an order to liquidate the
position. That is, if you bought and cannot pay, your contract will be put up for
sale at the next opening, as if you had ordered to sell the contract; and if you were
short, your contract will likewise be closed out the next day as if you had ordered to
buy. This way, the Exchange finds a new party that steps into your shoes. The loss
or gain on this last deal is yours, and is added to or subtracted from the margin.
Example 6.8
When Nick Leeson had gambled his employer, the then 233-year-old Barings bank,
into ruin he had accumulated losses ofgbp800m, more than Barings’ entire equity.
But the Singapore Exchange lost “only” 50m. Barings London had sent Nick about
500m for m-to-m payments (thinking these were deposits or something like that),
and Nick had “borrowed” about 250m from other customers’ accounts to pay even
more margin without telling London. So the SME was already covered for about
gbp750m. The balance was lost when Nick’s huge open positions were liquidated
at short notice and when the initial margin proved totally inadequate to cover the
losses caused by the massive price pressure.
6.2.3 Organized Markets
As we saw, forward contracts are not really traded; they are simply initiated in the
over-the-counter market (typically with the client’s bank) and held until maturity.
In the forward market, market makers quote prices but there is no organized way
of centralizing demand and supply. The only mechanisms that tend to equalize the
prices quoted by different market makers are arbitrage and least cost dealing; and, as
traders are in permanent contact with only a few market makers, price equalization