Meaning
Performance costs arise when cash must be repeatedly transferred to cover daily changes in the value of derivative contracts or hedged positions. The phenomenon of variation margin drag refers to the loss of potential investment returns because capital is held in low-yield cash accounts to meet these daily margin calls. This liquidity drain reduces the funding available for core business operations and inventory purchases.
The effect is absent when hedging positions are cleared using non-cash assets or when market prices remain stable.
Cost Origin
Derivatives are used by commodity distributors to lock in purchasing prices and protect margins from currency shifts. When the market moves against the hedge, the distributor must immediately post cash to the exchange or clearinghouse. These daily cash outflows cannot be used to fund ongoing shipping and warehousing operations.
The resulting cash constraint can slow down product movement and distribution schedules.
Capital Constraint
Holding cash in reserve to meet volatile margin requirements increases the working capital needed to run a distribution network. This requirement reduces the return on capital employed, as substantial funds sit idle rather than earning higher returns in the business. If the market experiences a prolonged period of high volatility, the drag on profitability becomes substantial and can force the company to reduce its trading volumes.
Distributors must often secure expensive lines of credit to ensure they have enough cash to cover these margin calls. This additional debt raises the total landed cost of the goods and lowers net margins.
Risk Mitigation
Supply contracts and hedging policies must balance the safety of locked-in prices against the cash flow risk of margin calls. Some agreements allow for the use of bank guarantees or letters of credit to satisfy margin requirements instead of cash. These non-cash collateral options help maintain liquidity and reduce the drag on operating capital.
This strategy keeps distribution channels fully funded during market fluctuations.
