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

Author

Listed:
  • Herbert L. Baer
  • Virginia G. France
  • James T. Moser

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.

Suggested Citation

  • Herbert L. Baer & Virginia G. France & James T. Moser, 2001. "Opportunity cost and prudentiality: an analysis of collateral decisions in bilateral and multilateral settings," Working Paper Series WP-01-26, Federal Reserve Bank of Chicago.
    • Handle: RePEc:fip:fedhwp:wp-01-26
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    Cited by:

    1. Nahai-Williamson, Paul & Ota, Tomohiro & Vital, Mathieu & Wetherilt, Anne, 2013. "Financial Stability Paper No 19: Central counterparties and their financial resources – a numerical approach," Bank of England Financial Stability Papers 19, Bank of England.
    2. James T. Moser, 2002. "The immediacy implications of exchange organization," Working Paper Series WP-02-09, Federal Reserve Bank of Chicago.
    3. Yaron Leitner, 2003. "Non-exclusive contracts, collateralized trade, and a theory of an exchange," Working Papers 03-3, Federal Reserve Bank of Philadelphia.
    4. Olga Lewandowska, 2015. "OTC Clearing Arrangements for Bank Systemic Risk Regulation: A Simulation Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 47(6), pages 1177-1203, September.
    5. Yaron Leitner, 2004. "Non-Exclusive Contracts, Collateralized Trade, and a Theory of an Exchange," Econometric Society 2004 North American Winter Meetings 397, Econometric Society.
    6. John P Jackson & Mark J Manning, 2007. "Comparing the pre-settlement risk implications of alternative clearing arrangements," Bank of England working papers 321, Bank of England.
    7. Kahn, Charles M. & Roberds, William, 2009. "Why pay? An introduction to payments economics," Journal of Financial Intermediation, Elsevier, vol. 18(1), pages 1-23, January.

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