Opportunity Cost and Prudentiality: An Analysis of Futures Clearinghouse Behavior

 

by Herbert L. Baer, Virgina G. France, and James T. Moser*


*The authors are Financial Economist at the World Bank Policy Research Department; Assistant Professor at the University of Illinois at Urbana-Champaign; and Senior Economist at the Federal Reserve Bank of Chicago respectively. 

 
 

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. Comments may be addressed to the third author at (312) 322-5769; or the middle author at V-FRANCE@UIUC.EDU

Download a complete Word Perfect version of the paper: OFOR9601.rtf

Download the Tables: TAB9601.rtf

Both the paper and tables are in Word Perfect format. If you have any problems downloading the paper or tables please contact fmattos@uiuc.edu

Return to OFOR homepage