A Theoretical Framework to Evaluate Different Margin - Setting Methodologies

The margin system is the clearinghouse’s first line of defense against default risk. From the perspectives of a clearinghouse, the utmost concern is to have a prudential system to control the default exposure. Once the level of prudentiality is set the next concern of the clearinghouse is overcharge. It is because higher is the overcharge, greater is the investor’s opportunity cost of investing in the futures market. In this paper, we develop different measures of prudentiality and overcharge. We then formulate a theoretical framework to evaluate different margin setting methodologies. Three margin-setting methodologies, namely, one using simple moving averages, one using exponentially weighted moving averages, and the other using a GARCH approach, are applied to the Hang Seng Index Futures and are compared under our theoretical framework. Keeping the same prudentiality level, it is shown that the one using a GARCH approach by and large gives the lowest average overcharge. JEL Classification: G14, G15 Keyword(s): Coverage probability, margin-setting methodology, opportunity cost, overcharge, prudentiality, shortfall. Acknowledgments: K. Lam would like to thank the financial support by the Research Grants Council of the Hong Kong Special Administrati ve Region Government, in the form of an earmarked grant (HKBU2069/00H). We are also grateful to the comments from the participants of the seminar at Hong Kong Exchange and Clearing, of the seminar at Hong Kong Institute for Monetary Research, and of the Financial Management Association Conference. Please do not quote without authors’ consent.