To identify the worst probable one-day loss on a portfolio, SPAN® constructs a series of scenarios of changing underlying prices and volatilities for each derivative instrument in the portfolio, these "risk arrays" are central 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 minimum 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.

 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® is 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 gains and losses at the portfolio level. The largest loss recorded from this process is used as the "scanning loss" for the portfolio.

 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 containing futures and options with different expirations.

For each futures contract or other underlying instrument in which the portfolio 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.

 A new feature of London SPAN® version 4 is its "Strategy Spread functionality". 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.

 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 instrument. SPAN® uses delta information to generate spreads, and the more of a portfolio's delta which is allocated to spreads, the greater the spread credit for the portfolio.

 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.