Margin Adequacy and Standards: An Analysis of the Crude Oil Futures Market

Abstract

This paper proposes two value-based standards for setting the initial margin requirements on futures positions. Our approach is based on the fact that the distributions of the payoffs to futures traders and the potential losses to the futures clearinghouse can be described in terms of the payoffs to barrier options with appropriately defined strike prices and knockout boundaries. Based on this observation, we argue that initial margin requirements are adequate if the initial margin that must be posted is either (1) equal to the ex ante value of the payoffs to the futures position or (2) sufficient to reduce the value of the potential losses absorbed by the futures clearinghouse to zero. Using a numerical valuation approach that incorporates the stochastic volatility of the futures market, we examine the adequacy of margin requirements in the crude oil futures market. Our results suggest that on average the initial margin requirements set by the New York Mercantile Exchange have been in excess of the minimum margins required under our option-based standards for adequacy

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