Optimal Margin Levels in Futures Markets: A Parametric Extreme-Based Method
London Business School Institute of Finance and Accounting Working Paper 192
Posted: 10 Sep 1999
Margin committees and brokers in futures markets face a trade-off when setting the margin level. A high level protects brokers against insolvent customers and then reinforces market integrity, but it also increases the cost supported by investors and in the end makes the market less attractive. In this paper I develop a new method of setting the margin level in futures markets. I use extreme value theory to derive the margin level for a given probability of a margin violation desired by margin committees or brokers. Extreme movements are central to the problem of margin setting since only a large price variation may cause brokers to incur losses. The method takes into account the appropriate amount of extremes in the distribution of price changes and provides a simple analytical formula to compute the margin level. The comparison with a method based on normality shows that using normality leads to a dramatically underestimated margin level.
JEL Classification: G13
Suggested Citation: Suggested Citation