Working Paper

Opportunity cost and prudentiality: an analysis of collateral decisions in bilateral and multilateral settings

Abstract: This paper develops a model that 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 balance the deadweight costs of default against the opportunity costs of holding additional margin. Once created, it may be optimal for the clearinghouse to monitor the financial condition of its members. If undertake, monitoring will reduce the amount of margin required but need not affect 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 test suggest the opportunity cost of margin plays an important role in clearinghouse behavior particularly their determination of margin amounts. The relationship between volatility and margins suggests that participants face an upward-sloping opportunity cost of margin. This appears to dominate the effects of monitoring and expulsion might have on margin setting.

Keywords: Clearinghouses (Banking); Futures; Margins (Security trading);

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2001

Number: WP-01-26