A margin scheme that advises on when to change required margin

Lam, Kin, Yu, P. L.H. and Lee, P. H. (2010) A margin scheme that advises on when to change required margin. European Journal of Operational Research, 207 (1), 524-530. (doi:10.1016/j.ejor.2010.04.028).

Abstract

The purpose of a margin requirement is to protect a clearinghouse from members' defaults resulting from big losses due to adverse movement of futures prices. To decide on how much a margin is required, a clearinghouse may refer to a benchmark margin defined as a constant multiple of the forecasted volatility. However, a benchmark margin only advises on a desirable margin level. It gives no advice on whether a clearinghouse should alter existing required margin. This paper proposes a margin scheme that can advise on when to change the required margin and if a change is recommended, to what level it should be changed. The proposed margin scheme can be devised so that the coverage probability and change frequency are controlled at target levels deemed appropriate by the clearinghouse. The proposed margin scheme needs a volatility forecast as input. This paper shows that among a large number of volatility forecasts, implied volatility gives the best results. This confirms a conjecture that implied volatility may have more information content than other volatility forecasts as far as margin setting is concerned.

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Contributors

Author: P. H. Lee

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