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Price limits, margin requirements, and default risk

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  • Pin‐Huang Chou
  • Mei‐Chen Lin
  • Min‐Teh Yu

Abstract

This article investigates whether price limits can reduce the default risk and lower the effective margin requirement for a self‐enforcing futures contract by considering one more period beyond Brennan’s (1986) model to take into account the spillover of unrealized residual shocks due to price limits. The results show that, when traders receive no additional information, price limits can reduce the margin requirement and eliminate the default probability at the expense of a higher liquidity cost due to trading interruptions. Consequently, the total contract cost is higher than of that without price limits. When traders receive additional signals about the equilibrium price, we find that the optimal margin remains unchanged with or without the imposition of price limits, a result that is in conflict with Brennan’s assertion. Hence, we conclude that price limits may not be effective in improving the performance of a futures contract. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20:573–602, 2000

Suggested Citation

  • Pin‐Huang Chou & Mei‐Chen Lin & Min‐Teh Yu, 2000. "Price limits, margin requirements, and default risk," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 20(6), pages 573-602, July.
    • Handle: RePEc:wly:jfutmk:v:20:y:2000:i:6:p:573-602
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    Cited by:

    1. Cheng Xiang & Jing Lu, 2023. "Magnet effects of circuit breakers in electronic order‐driven markets: Evidence from China," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 28(2), pages 1450-1469, April.
    2. Arie Harel & Giora Harpaz & Joseph Yagil, 2005. "Forecasting futures returns in the presence of price limits," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 25(2), pages 199-210, February.
    3. Aktas, Osman Ulas & Kryzanowski, Lawrence & Zhang, Jie, 2021. "Volatility spillover around price limits in an emerging market," Finance Research Letters, Elsevier, vol. 39(C).
    4. Chen-Yu Chen & Jian-Hsin Chou & Hung-Gay Fung & Yiuman Tse, 2017. "Setting the futures margin with price limits: the case for single-stock futures," Review of Quantitative Finance and Accounting, Springer, vol. 48(1), pages 219-237, January.
    5. Xiong Xiong & Ding Nan & Yang Yang & Zhang Yongjie, 2015. "Study on Market Stability and Price Limit of Chinese Stock Index Futures Market: An Agent-Based Modeling Perspective," PLOS ONE, Public Library of Science, vol. 10(11), pages 1-12, November.

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