Forecasting initial margin requirements: A model evaluation

IN MY judgment," maintained William McChesney Martin, Jr., Chairman of the Board of Governors, Federal Reserve System, "we can never under the present margin regulations have the same result that occurred in terms of a financial crash in 1929 through undermargined accounts, low margins resulting in a financial debacle."' A widely used elementary economics textbook claimed, "Margin requirements have exercised an important restrictive influence on security speculation, as contrasted with the uncontrolled period of the late 1920's... Nearly everyone agrees that Federal Reserve margin requirements exercise a healthy restraint on speculative stock purchases in a boom" (Bach, 1963, p. 116). But what evidence is there that margin requirements have the effects claimed? At the December meetings of the American Economic Association, George J. Stigler, in the Presidential address, called on economists to test their assumptions that state regulation of private activity has indeed been successful (Stigler, 1965). This article brings together some data on the efficacy of margin requirements. While the figures can only be considered preliminary, and more data should be collected to test margin requirements, the data that are available and presented here indicate that not one of the aims of the legislation establishing margin requirements has been accomplished.2

Procyclicality of CCP Margin Models: Systemic Problems Need Systemic Approaches

A simple overlapping generations model is used to characterize the effects of initial margin requirements on the volatility of risky asset prices. Investors are assumed to exhibit heterogeneous preferences for risk-bearing, the distribution of which evolves stochastically across generations. This framework is used to show that imposing a binding initial margin requirement may either increase or decrease stock price volatility, depending upon the microeconomic structure behind fluctuations in economy-wide average risk-bearing propensity. The ambiguous effect on volatility similarly arises when the source of heterogeneity is noise trader beliefs. BEYOND THEIR PRUDENTIAL FUNCTIONS, the effects of initial margin requirements on securities markets are not well understood. Many have argued, based upon empirical findings, that the level of margin requirements has no discernable impact on stock price behavior.' Nevertheless, the view that high margin requirements dampen speculative excesses and reduce excess price volatility remains popular. The simultaneous existence of such views highlights the uncertainty surrounding this issue. In fact, there exists no rigorously articulated theory of the interaction between initial margin requirements and stock prices and their returns' characteristics. In this paper we construct a simple dynamic model useful for characterizing the effects of initial margin requirements on security prices and returns. To analyze the impact of margins, we introduce investor heterogeneity into an otherwise simplified overlapping generations (OLG) economy.2 The OLG models are constructed so that each generation displays heterogeneous preferences or beliefs, the distribution of which evolves stochastically across generations. In each of two heterogeneous taste models we consider there are two types of agents, one of which is more risk tolerant than the other. In one model, the

8 - Margin and collateral

This article investigates the relationship between initial margin requirements and stock return volatility. Volatility is measured using a GARCH in Mean model. We find no evidence of an empirical relationship between margin requirements and the volatility of the S&P 500 index portfolio's excess returns. Evidence from short-sale data, and model sensitivity analysis are presented which support the hypothesis of no margin-volatility relationship. The results are consistent with the intertemporal CAPM model of Merton (1973) with an aggregate relative risk aversion measure of 4.1. In addition, we find evidence of long-term memory in conditional return distributions' volatility.

CCP Clearing Demystified

Initial margin requirements represent: (1) a cost impediment to the wealth constrained investor and (2) a potential way of mitigating excessive volatility. However, prior empirical research finds that margins are not an effective tool in reducing volatility. We consider the possibility that margins primarily affect certain stocks and investors. Specifically, we test whether margins affect individuals who, as a group, we believe to be the investors most affected when margin requirements change. Our initial empirical tests, however, do not support this contention.

Central Clearing and Collateral Demand

We use an extensive data set of bilateral exposures on credit default swap (CDS) to estimate the impact on collateral demand of new margin and clearing practices and regulations. We decompose collateral demand for both customers and dealers into several key components, including the "velocity drag" associated with variation margin movements. We demonstrate the impact on collateral demand of more widespread initial margin requirements, increased novation of CDS to central clearing parties (CCPs), an increase in the number of clearing members, the proliferation of CCPs of both specialized and non-specialized types, and client clearing. Among other results, we show that system-wide collateral demand is increased significantly by the application of initial margin requirements for dealers, whether or not the CDS are cleared. Given these dealer-to-dealer initial margin requirements, however, mandatory central clearing is shown to lower, not raise, system-wide collateral demand, provided there is no significant proliferation of CCPs. Central clearing does, however, have significant distributional consequences for collateral requirements across various types of market participants.

•Most recently valued at $648 trillion, the over-the-counter (OTC) derivatives markets are vast, global and systemically important. About 90 per cent of these transactions are agreed on International Swaps and Derivatives Association’s (ISDA’s) standard terms, which provide for disputes to be resolved by the courts of England and Wales, or New York (though some parties amend this drafting). •This article presents research into all the available decisions of the English courts involving the ISDA standard terms. Analysis of this data demonstrates the courts’ capacity to provide a remedy for derivatives market participants in a very wide range of circumstances. It also shows how adjudication by the courts sustains the common law and increases transparency in the markets. •Triggered by the G20’s statements in the immediate aftermath of the crisis, regulators are now engaged in sweeping projects of reform in this sector. However, the impact of new rules on the courts has been overlooked. •The article argues that reforms targeting the OTC sector threaten to disrupt the role currently played by the courts in these markets. More specifically, a detailed examination of the internal rules of central counterparties (CCPs) suggests that requiring the bulk of OTC business to be cleared is very likely to reduce the numbers of OTC derivatives related cases coming before the national courts. Especially given regulators’ concern with transparency, the article concludes that these effects need to be considered urgently, and in detail, as part of the impact assessments accompanying regulatory reform.

Regression Sensitivities for Initial Margin Calculations

An Investigation into the Procyclicality of Risk-Based Initial Margin Models

This chapter provides an introduction to over-the-counter (OTC) derivatives clearing documentation. It sets out an overview of the legal framework and key concepts underpinning OTC clearing and discusses the supporting documentation. These include the central counterparty (CCP) rules, the International Swaps and Derivatives Association/Futures Industry Association (ISDA/FIA) Cleared Derivatives Execution Agreement, the ISDA/FIA Client Cleared OTC Derivatives Addendum, the FIA Clearing Module, collateral documentation, and related legal opinions. The chapter also examines considerations arising from regulatory obligations and other developments, some of which may also give rise to documentation requirements. These include the European Market Infrastructure Regulation (EMIR) Art. 39(7) disclosure requirements; the Markets in Financial Instruments Directive II (MiFID II), and the Markets in Financial Instruments Regulation (MiFIR) Model Provisions for the Addendum; EMIR requirements to provide clearing services under fair, reasonable, non-discriminatory, and transparent (FRANDT) commercial terms; and changes to CCP rules.

Purpose Risk-based clearing has been proposed by Rausser et al. (2010) for over-the-counter (OTC) derivatives. This paper aims to illustrate the application of risk-based margins to a case study of the mortgage-backed securities derivative portfolio of the American International Group (AIG) during the period 2005-2008. There exists sufficient publicly available information to examine AIG’s derivative portfolio and how that portfolio would depend on conjectural changes in margin requirements imposed on its OTC derivative positions. Generally, such data on OTC derivative portfolio positions are unavailable in the public domain, and thus, the AIG data provide a unique opportunity for an objective evaluation. Design/methodology/approach This paper uses modern financial methodology to evaluate risk-based margining and collateralization for the major OTC derivative portfolio of the AIG. Findings This analysis reveals that a risk-based margin procedure would have led to earlier margin calls of greater magnitude initially than the collateral calls actually faced by AIG Financial Products (AIGFP). The total margin ultimately required by the risk-based procedure, however, is similar in magnitude to the collateral calls faced by AIGFP by August 2008. It is likely that a risk-based clearing procedure applied to AIG’s OTC contracts would have led to the AIG undertaking significant hedging and liquidation of their OTC positions well before the losses built up to the point they had, perhaps avoiding the federal government’s orchestrated restructuring that occurred in September 2008. Originality/value There has been no published risk-based evaluations of a major OTC portfolio of derivatives for any company, let alone the AIG.

Credit Derivative Theory & Practice A Credit Primer & Review of the Impact of ISDA Standardization on Credit Default Swap Pricing & Credit Model Calibration