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Title: Opportunity Cost and Prudentiality: An Analysis of Futures Clearinghouse Behavior
Author(s): Baer, Herbert L.; France, Virginia G.; Moser, James T.
Subject(s): futures clearinghouse
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.
Issue Date: 1996-01
Publisher: Office for Futures and Options Research, Department of Agricultural Economics, College of Agricultural, Consumer, and Environmental Sciences at the University of Illinois at Urbana-Champaign
Series/Report: OFOR Working Paper Series, no. 96-01
Genre: Working / Discussion Paper
Type: Text
Language: English
Publication Status: published or submitted for publication
Peer Reviewed: not peer reviewed
Date Available in IDEALS: 2008-03-18

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