The Impulsive Approach to Procyclicality. Measuring the Reactiveness of Risk-based Initial Margin Models to Changes in Market Conditions Using Impulse Response Functions

27 Pages Posted: 21 Feb 2024 Last revised: 30 Aug 2024

See all articles by Pedro Gurrola-Perez

Pedro Gurrola-Perez

World Federation of Exchanges

David Murphy

London School of Economics - Law School

Date Written: February 15, 2024

Abstract

In recent years, many derivatives market participants received large margin calls in episodes of elevated market volatility such as the onset of the Covid-19 global pandemic and the illegal Russian invasion of Ukraine. The lack of some market participants’ preparedness to meet margin increases resulted in liquidity stress and reinvigorated the policy debate about how reactive margin should be to changes in market conditions. This debate has been hampered by the lack of a generally accepted way of measuring the reactiveness of the models used to calculate initial margin. The first contribution of this paper is to provide such a measure. We consider a step function in volatility, and examine the responses of various initial margin models to paths of risk factor returns consistent with this impulse, introducing the impulse response function as a convenient means of presenting this reaction. The results presented demonstrate that a model’s impulse response is a robust and useful measure of its reactiveness. This approach could be used both to measure initial margin model reactiveness, or procyclicality as it is often termed, and to capture the uncertainty in this measurement. It also provides significant, novel insights into the behaviour of some economically important margin models. In particular, the tendency of some filtered historical simulation value at risk models to over-react to sharp stepwise increases in volatility is demonstrated and the reasons for it are explored. The behaviour of two widely-used anti-procyclicality tools, the buffer and the use of a stressed period, are also analysed: the latter is found to be more successful at mitigating procyclicality than the former. The paper concludes with a discussion of the policy implications of the results presented.

Keywords: Anti-procyclicality, impulse response function, initial margin model, margin model response, procyclicality, volatility estimation

JEL Classification: G13, C52, C12

Suggested Citation

Gurrola Perez, Pedro and Murphy, David, The Impulsive Approach to Procyclicality. Measuring the Reactiveness of Risk-based Initial Margin Models to Changes in Market Conditions Using Impulse Response Functions (February 15, 2024). Proceedings of WFEClear: The WFE’s Clearing & Derivatives Conference 2024, Available at SSRN: https://ssrn.com/abstract=4727725 or http://dx.doi.org/10.2139/ssrn.4727725

Pedro Gurrola Perez (Contact Author)

World Federation of Exchanges ( email )

125 Old Broad Street
London, EC2N 1AR
United Kingdom
EC2N 1AR (Fax)

HOME PAGE: http://www.world-exchanges.org

David Murphy

London School of Economics - Law School

Houghton Street
London WC2A 2AE, WC2A 2AE
United Kingdom

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