Optimal margin level in futures markets: Extreme price movements

Abstract

Along with price limits and capital requirements, the margin mechanism ensures the integrity of futures markets. 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 thus reinforces market integrity, but it also increases the cost supported by investors and in the end makes the market less attractive. This article develops a new method for setting the margin level in futures markets. It is based on “extreme value theory,” which gives interesting results on the distribution of extreme values of a random process. This extreme value distribution is used to compute the margin level for a given probability value of margin violation desired by margin committees or brokers. Extreme movements are central to the margin-setting problem, because only a large price variation may cause brokers to incur losses. An empirical study using prices of silver futures contracts traded on COMEX is also presented. The comparison of the extreme value method with a method based on normality shows that using normality leads to dramatic underestimates of the margin level. © 1999 John Wiley & Sons, Inc. Jrl Fut Mark 19: 127–152, 1999