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Opportunity Cost and Prudentiality: An Analysis of Futures Clearinghouse Behavior

OFOR Working Paper 96-01

Posted: 26 Jun 1998  

Virginia G. France

University of Illinois at Urbana-Champaign

Herbert L. Baer

World Bank

James T. Moser

American University - Kogod School of Business

Date Written: May 1996

Abstract

This paper develops a model which explains how the creation of a futures clearinghouse allows traders to reduce default and economize on margin. We contrast the collateral necessary between bilateral partners with that required when multilateral netting occurs. Optimal margin levels are determined by the need to balance the deadweight costs of default against the opportunity costs of holding additional margin. Once created, it may (but need not) be optimal for the clearinghouse to monitor the financial condition of its members. If undertaken, monitoring will reduce the amount of margin required but need not have any effect on the probability of default. Once created, it becomes optimal for the clearinghouse membership to expel defaulting members. This reduces the probability of default. Our empirical tests suggest that the opportunity cost of margin plays an important role in margin determination. The relationship between volatility and margins indicates that participants face an upward sloping opportunity cost of margin. This appears to more than offset the effects that monitoring and expulsion would be expected to have on margin setting.

JEL Classification: G13, G2

Suggested Citation

France, Virginia G. and Baer, Herbert L. and Moser, James T., Opportunity Cost and Prudentiality: An Analysis of Futures Clearinghouse Behavior (May 1996 ). OFOR Working Paper 96-01. Available at SSRN: https://ssrn.com/abstract=7438

Virginia Grace France (Contact Author)

University of Illinois at Urbana-Champaign ( email )

198 Commerce West
Urbana, IL 61801
United States
217-333-0704 (Phone)
217-244-3102 (Fax)

Herbert L. Baer

World Bank

1818 H Street, N.W.
Washington, DC 20433
United States

James T. Moser

American University - Kogod School of Business ( email )

4400 Massachusetts Avenue NW
Washington, DC 20816-8044
United States

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