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Appendix 9

SPAN

What is SPAN

Standard Portfolio Analysis of Risk (SPAN

) is a margining system used by

LCH.Clearnet to calculate initial margins due from and to its clearing mem-

bers. SPAN

is a computerised system which calculates the effect of a range

of possible changes in price and volatility on portfolios of derivatives. The

worst probable loss calculated by the system is then used as the initial mar-

gin requirement.

Initial margin

All of Euronext.liffe’s London exchange traded products are centrally cleared

by LCH.Clearnet which acts as the central counterparty to all trades.

LCH.Clearnet guarantees the fulfillment of all trades transacted on

Euronext.liffe and as such assumes the risk of carrying all open positions

forward. This risk is hedged by charging margin on the risk exposure faced

by LCH.Clearnet to its clearing members. For LCH.Clearnet accurately to

assess this risk, and therefore the margin that they will charge their clearing

members, it needs an accurate means of assessing the potential risk it faces,

for both single and portfolios of derivative positions. LCH.Clearnet uses

London SPAN

for this purpose.

Identifying overall risk

The objective of SPAN

is to identify the overall risk inherent in a portfolio of

futures and options derivative contracts. SPAN

treats both futures and

options uniformly, while recognising the unique exposures associated with

options portfolios. Critically, SPAN

also recognises inter-month and inter-

commodity risk relationships, where the holding of one position may offset

the risk associated with holding another position and vice-versa.

London SPAN

’s overriding objective is to determine the largest loss (risk)

that a portfolio of derivative positions might be reasonably expected to suffer

over a period of time (worst probable loss). For Euronext.liffe, LCH.Clearnet

is responsible for determining what is a ‘reasonable’ worst possible loss, and

for setting the basic SPAN

parameters accordingly which will be used to cal-

culate margin requirements on its clearing members’ portfolios.

SPAN

methodology

To identify the worst probable one-day loss on a portfolio, SPAN

con-

structs a series of scenarios of changing underlying prices and volatilities

for each derivative instrument in the portfolio, these ‘risk arrays’ are cen-

tral to the SPAN

methodology, from this the worst probable outcome – the

scanning loss – is selected. SPAN

will then add up all the scanning losses

for the portfolio, add any inter-month spread charges and subtract any

inter-commodity credits. This is then compared to the ‘short option mini-

mum charge’ and whichever is the greater is the initial margin. This can be

represented by:

Initial margin  scanning loss  inter-month spread charge 

Inter-commodity charge credit

or; the short option minimum charge, whichever is the greater.

This is explained in greater detail below.

Scanning loss and risk arrays

The SPAN

risk array represents how a specific derivative contract (e.g. a

future or option on a future, or an option on a stock) will react (gain or lose

value), from the current point in time to a specific point in time in the future

(usually the following day), to a specific set of market conditions over this

time duration. The time duration is typically one trading day as SPAN

primarily concerned with assessing the worst probable loss which may occur

from one trading day to another.

The market conditions that are evaluated are called ‘risk scenarios’. There

are sixteen risk scenarios and these are defined in terms of:

• how much the price of the underlying is expected to change over the

time duration;

• how much the volatility of the underlying will change over the time

duration.

The results of this calculation for each risk scenario – the amount by which

the derivative contract will gain or lose value over the time duration –

is called the risk array value. The set of risk array values for the specific

contract under the full set of risk scenarios constitutes the risk array. The

scanning range, that is the range at which SPAN

scans up and down from

the current underlying market price, is set and reviewed by LCH.Clearnet.

SPAN

uses the risk arrays to scan underlying market price changes and

volatility changes for all contracts in a portfolio in order to determine value

258 SPAN

gains and losses at the portfolio level. The largest loss recorded from this

process is used as the ‘scanning loss’ for the portfolio.

Inter-month spread charge

SPAN

assumes that price moves correlate perfectly across contract months.

However, since price moves across contract months rarely exhibit perfect

correlation, SPAN

adds an Inter-Month Spread Charge to the Scanning Loss

associated with each instrument. Effectively, this Inter-month Spread

Charge covers the inter-month basis risk that may exist for portfolios con-

taining futures and options with different expirations.

For each futures contract or other underlying instrument in which the port-

folio has positions, SPAN

identifies the net delta associated with it. SPAN

then creates spreads using these net deltas. As these spreads are created,

SPAN

keeps track of each tier (a set of consecutive futures contracts) of how

much delta has been consumed by spreading the tier, and how much

remains. For each spread formed, SPAN

assesses a charge per spread, the

total of all these charges for a particular commodity constitutes the inter-

month spread charge for that commodity.

Strategy spreads

A new feature of London SPAN

version 4 is its ‘Strategy Spread functional-

ity’. Here, consecutive Butterfly and Condor strategies with in a portfolio are

identified and processed at an appropriate rate, reflecting their lower risk

profile before the calculation of the inter-month spread charge. As such,

portfolios containing these strategies under London SPAN

version 4 will

benefit from the more accurate assessment of their risk.

These strategies are automatically identified by London SPAN

version 4

even if these positions were not created as a strategy.

Inter-commodity credits

Price movements tend to correlate fairly well between related underlying

instruments. As a result, gains from positions in one derivatives instrument

will sometimes offset losses in another related instrument. Therefore to

recognise the risk reducing aspects of portfolios that contain positions in

related derivative instruments, SPAN

will form inter-commodity spreads for

these positions. These spreads produce credits that in the final calculation of

the initial margin, may reduce that margin.

Each spread formed by SPAN

generates a percentage saving from the

total initial margin requirement for the underlying instrument. SPAN

applies these percentages to the outright initial margin requirements and in

most cases derives a lower initial margin requirement for the specific instru-

ment. SPAN

uses delta information to generate spreads, and the more of a

SPAN 259

portfolio’s delta which is allocated to spreads, the greater the spread credit

for the portfolio.

Short options minimum charge

Short options positions in extremely out-of-the-money strikes may appear to

have little or no risk across the entire scanning range. However, in the event

that the underlying market conditions change significantly these options

may move into-the-money and may generate large losses for holders of short

positions in these options. To cover this risk, SPAN

allocates a minimum

requirement for each short option contained in a portfolio. The Short Option

Minimum Charge acts as the lower boundary to the risk requirement for

each underlying instrument. The risk requirement for the instrument in

question cannot fall below this level.

Definitions

Initial margin The returnable deposit required by LCH.Clearnet from its

members when opening certain futures and options posi-

tions. Initial margin is usually calculated by taking the

worst probable loss that the position could sustain, and

can be paid in either cash or collateral.

Scanning loss A term used to describe the initial margin calculated by

SPAN

. The scanning loss will be the worst-case potential

risk in a portfolio of derivatives across a range of changes in

price and volatility as calculated by the SPAN

system.

Source: LCH.Clearnet.

260 SPAN

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