A Theoretical Framework to Evaluate Different Margin-Setting Methodologies: with an Application to Hang Seng Index Futures

The margin system is a clearinghouse’s first line of defense against the 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 is the opportunity cost to the investors. It is because high opportunity cost discourages people from hedging futures and thus defeats the function of a futures market. In this paper, we first develop different measures of prudentiality and opportunity cost. We then formulate a statistical framework to evaluate different margin-setting methodologies, all of which strike a balance between prudentiality and opportunity cost. Four margin-setting methodologies, namely, one using simple moving averages, one using exponentially weighted moving averages, one using a GARCH-GJR approach, and the last one using the lagged implied volatility (whenever it is available), are applied to Hang Seng Index Futures. The lagged implied volatility by and large has the best performance, while the GARCH-GJR approach is a best substitute when implied volatility is not available. JEL Classification: G14, G15 Keyword(s): Expected shortfall, implied volatility, margin-setting methodologies, opportunity cost, prudentiality, value-at-risk