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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO JUNE 1991 NUMBER 46 Chicago Fed Letter Futures m argin and excess volatility On October 19, 1987, the Dowjones Industrial Average dropped 22.61%, its largest ever percentage decline. The event aroused concern that the stock market was becoming exces sively volatile. The 6.91% decline on October 13, 1989, heightened these concerns. Some charge that the relatively low margin levels required for positions in stock index futures contribute to the magnitude of stock price changes. In particular, accord ing to this view, the problem is that margins required for stock futures are lower than margins required for stocks. According to this view, margin requirem ents for stocks and stock futures should be equal. I disagree with this claim. In this Chicago Fed Letter, I show why the usual arguments for margin equaliza tion, which refer to excessive volatil ity, are not convincing. I argue that margin equalization is an attempt to maintain the market share of trades placed by small investors. However, this attempt will fail be cause of competition from alternative markets. What are futures markets? Futures contracts are commitments requiring settlement based on cashmarket prices at some date in the future. Thus, futures markets are derivative markets; i.e., futures prices derive from the value of their under lying cash-market assets. For ex ample, futures contracts may be tied to agricultural products, foreign exchanges, interest rate obligations or stock market indexes. This aspect of the futures market provides certain advantages. Because futures positions can be held without provi sions for owning the underlying asset, the cost of entering a futures position is lower than the cost of the corresponding position in the cash market. Investors in futures markets need not pay financing or other costs to take positions based on their forecasts. This lower trading cost attracts investors to futures markets. As futures markets respond to the extent of investor positions, futures prices reflect the forecasts motivating these positions. What emerges is a consensus forecast of prices. Thus, futures speculations provide the economy with information about both expected future prices and risk. Businesses can use expected price information in forming plans. For example, the futures price for Trea sury bonds might be useful to under writers planning an offering of interest-sensitive securities. Diverse forecasts are likely to produce price swings in the futures market, imply ing uncertainty about future pros pects. This provides the economy with a forecast of risk. A diverse set of forecasts might suggest to manag ers that they need to reduce their firms’ exposure to price changes. For example, observing increased volatility in interest-sensitive futures, underwriters will increase their measures to prevent losses from the issue. The following example illustrates this price-discovery process. Suppose that Jamie, an investor, believes long term Treasury bonds are underval ued; that is, Jamie believes that interest rates are presently too high. The cash market position taking advantage of this insight is purchase of long-term Treasury bonds. This long position in bonds ties up invest m ent capital. A long position in a bond-futures contract enables Jamie to take a related position using less capital. Thus, with limited supplies of capital, Jamie can take larger positions in the futures market than in the cash market. The marketplace benefits because the greater extent of the Jam ie’s position increases upward price pressure on futures contracts relative to its effect were Jamie limited to cash bonds. In turn, arbitrage between the two markets assures that whatever information is reflected in futures contract prices will quickly be used in pricing the cash bond. In summary, valuation forecasts motivate investment. The choice of investment vehicle is based on maximum benefit. When futures contracts lower the cost of invest ment, prices respond to new infor mation more rapidly. As a result, prices are more informative. The link between prices in futures and in cash markets demonstrated in the example also illustrates the second benefit of futures markets: risk management. Because the futures and cash prices move closely together, other investors already holding bonds, or long cash posi tions, can take short positions in futures contracts to avoid the risk of price changes. Returns from these short positions offset the price changes of the long cash position, reducing investor risk. This offset occurs because long and short positions respond differently to price changes. Long positions produce gains when prices rise and losses when prices fall. Short positions produce losses when prices rise and gains when prices fall. Thus, simulta neous long cash and short futures positions produce offsetting returns. The ability to construct such combi nations enables investment managers to control exposure to price changes. Of course, managers can always accomplish risk control by altering their cash positions. The lower cost of trading in futures augments this ability. In summary, futures markets provide the market with enhanced price discovery and risk management facilities. Why some believe that margins are related to volatility The idea that margins are related to volatility is exceptionally long lived given the lack of evidence supporting this point of view. The reasoning behind this idea is that margin requirements determine speculation levels; and by controlling speculation, market volatility can be controlled. I call this the Exces sive Volatility Argument. There are a num ber of objections to this argument. Initial stock margins are set by the Federal Reserve Board of Governors. Since 1975, initial stock margins have been 50%; i.e., investors holding margined stock positions must have an initial equity stake in the position of 50%. Prior to 1975, the Board revised stock margin requirements intending to quiet markets. By raising the cost of speculating in stocks, it was hoped that volatility could be controlled. Repeated examination of the use of margin rules to control volatility indicates that it was not successful. There are good reasons for the lack of success. First, the extent of margin positions is too small. Regulation affecting only a small portion of trading activity is unlikely to have much of an impact. Second, margin rules restrict the use of stock as collateral. This restriction is readily avoided by basing the loan on other assets. Third, as Franco Modigliani and Merton Miller demonstrated years ago, the m ethod of financing does not alter the fundam ental perfor mance of assets. The fact that chang ing margin requirem ents failed to reduce volatility explains why, de spite retaining the authority, the Board has opted to leave initial margin requirem ents unchanged since 1975. This well docum ented failure of regulation in the stock market suggests that the use of margins to reduce volatility in the futures mar ket will fail as well. Even if margin regulation did reduce volatility in the stock market, it would not necessarily work in the futures market because margin serves a distinctly different purpose in the futures markets. Whereas stock margins serve as collateral for loans secured by stock, futures margins are security deposits maintained daily to ensure perfor mance of the contract holder. The guarantee that futures exchanges provide to the counterparties in contracts traded on the exchange places the exchange at risk. The exchange faces the risk that contract terms will not be performed. Margin balances manage exchange risk in two ways. First, as long as the margin deposit exceeds a zero balance, futures traders failing to perform lose their margin deposits. This loss threat provides them with an eco nomic incentive to fulfill contract terms as long as the cost of perfor mance is less than the amount remaining in the margin account. Second, should nonperform ance occur, the exchange uses available margin to reduce its cost of complet ing the contract terms. In my research, there is no evidence that raising margins reduces subse quent volatility.1 On the contrary, the evidence indicates that futures exchanges raise margins when volatility increases. Thus, just as the above arguments predict, exchanges act prudendaily. They raise margins when the risk of nonperform ance increases. The Excessive Volatility Argument also assumes that speculation in creases volatility. However, the opposite result is more likely. Specu lators often take positions against the market. For example, betting that the market price is too low, specula tors will buy. Thus, markets re garded as declining attract specula tors who place buy orders, guessing the market to be too bearish. Specu lation then, tends to reduce volatility. The lower margin requirem ents of futures markets probably does attract speculators, but it does not follow that these speculators increase volatility. Lastly, is the stock market really more volatile since futures began trading in 1982? It might seem that the answer is yes, given what hap pened in the Octobers of 1987 and 1989, but these were very short-term events. It is inappropriate to charac terize long periods of time by short term results. Figure 1 graphs quarterto-quarter percentage changes in the Standard and Poor’s 500 from 1952 to 1990. According to the Figure, the magnitude of up and down price changes does not suggest that an im portant change in volatility has occurred since 1982. Even the price swings in the last quarters of 1987 and 1989 are less dramatic than those during 1974. In fact, statistical studies examining the effect on volatility from the introduction of stock index futures find the opposite has occurred. Volatility has declined since their introduction. Thus, stock index futures did not raise volatility. Is there another explanation? Both logic and evidence run counter to the claim that futures margins need to be increased. Why then does the debate continue? A better explanation for the interest in raising futures margins can be gleaned from Figure 2. This graph compares the levels of new equity issues with direct ownership of equities by households. Since 1975, the two series steadily diverge, indicating that households began decreasing their shares of direct equity holdings. Households are the retail customers of the stock exchanges. Their de creased participation implies an increase in holdings of institutions such as pension funds and insurance companies—the wholesale customers 1. Volatility o f equity returns percentage price change (quarter-to-quarter) of the stock exchanges. As the graph indicates, the shift from direct household investment to indirect holdings through intermediating institutions accelerated during the mid-1970s. On May 1, 1975, the NYSE de-cartelized the brokerage industry by letting competition determine fees charged by brokers. The result was a retail-wholesale segmentation of customers. Broker age fees obtained from these two different customer bases differ predictably. Retail customers are charged higher amounts for two reasons. First, retail trades are smaller and more costly to handle. This extra handling justifies a higher charge per transaction. Second, retail customers have fewer alterna tives. While wholesale customers can shop off-exchange for lower transac tion fees, retail customers lack the trading volume to justify the expense of this search. Failure to discount the transactions of wholesale custom ers will push these institutions to alternative markets. The lack of alternatives for small investors lessens the pressure to offer them discounts. Consequently, though trades by small investors represent less than 15% of average trades by volume, these are the highest markup trades in today’s market.2 Retaining these high-markup custom ers is vital to the present day trading system used by the stock exchanges. Proponents of the Excessive Volatility Argument claim that volatility ex cesses cause small investors to leave the stock market. However, if this is true, the investment dollars placed by small investors do not disappear. They are re-routed through interm e diating firms. This re-routing shifts trades from the retail market into the wholesale market. This insight clarifies the concerns of the stock exchange: replacing the highmarkup end of its business with more low-markup business implies losses. Thus, margin equalization is in tended to retain this im portant customer base by controlling excess volatility. However, as previously pointed out, raising futures margins does not lower volatility. Margin equalization does affect the retail customer base in other ways. Intermediary institutions offer return-enhancing and risk-manage m ent services to individuals. These services are uneconomic for small investors. For example, a pension fund can use index arbitrage to enhance the retirem ent accounts of its membership. Individuals will generally find that returns net of transaction costs are insufficient to justify this strategy. Similarly, portfo lio insurance is generally uneco nomic for individuals, but usefully provided by intermediaries. In creased trading costs brought on by higher margins diminish the ability of intermediary institutions to offer Karl A. S cheld, S en io r Vice P re sid e n t a n d D irecto r o f R esearch; David R. A llardice, Vice P re sid e n t a n d A ssistant D irecto r o f R esearch; C arolyn M cM ullen, E ditor. Chicago Fed Letter is p u b lish e d m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o r s ’ a n d are n o t necessarily th o se o f th e F ed eral Reserve B ank o f C hicag o o r th e F ed eral R eserve System. A rticles m ay b e r e p rin te d if th e so u rce is c re d ite d a n d th e R esearch D e p a rtm e n t is p ro v id ed w ith copies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t ch arg e fro m th e Public In fo rm a tio n C e n te r, F ed eral R eserve B ank o f C hicago, P.O . Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 these services to customers. Thus, equalizing margin stems the shift from retail to wholesale trades by making the benefits from trading futures inaccessible to small investors. Suppose futures and stock margins are equalized? Raising futures margins to the present levels required for initial stock posi tions will raise the cost of futures trading, reducing the economic benefits from futures trading. Com petition ensures that efforts will be made to re-establish these benefits using products from alternative markets. The low-markup clients of the stock exchanges will continue seeking low-cost routes for their trades. Trading volume at computer facilities which match trades in the socalled off-exchange market will rise. Also, foreign exchanges will not hesitate to offer contracts replacing those presently trading in the futures markets of New York, Kansas City, and Chicago. These trades will be moti vated by competition between inter mediaries to increase the effectiveness of risk m anagement and return enhancement. As substitutes for futures trading are developed in off-exchange and overseas markets, wholesale firms will re-establish intermediary services. The presence of substantial whole sale-retail cost differentials assures these wholesalers of a market for these services. Strategies such as portfolio insurance and index arbi trage will remain uneconomic for high-markup customers. Continued underperform ance of self-managed investments relative to institutionmanaged portfolios will motivate further shifts from self-managed investments. Thus, attempts to forestall the loss of retail trades by raising the cost of trading in alternative markets will fail. High mark-up customers at tracted by the investment services offered by intermediaries will con tinue to place investments through intermediaries. Low mark-up cus tomers seeking to lower the cost of providing these services will move more trading to alternative markets. In combination, the stock exchanges will lose business to institutions facilitating increased returns and lower risk from trading activity. Conclusion The Excessive Volatility Argument links trading costs to excessive volatility from speculative activity. Proponents of margin equalization hope to raise the cost of trading futures to solve this problem. I have shown that the Excessive Volatility Argument fails because margin increases do not lower subsequent volatility. The proponents of margin equaliza tion may have another goal in mind. By raising the cost of trading strate gies designed to enhance returns and manage the risk of stock positions held through intermediaries, the exchanges seek to retain highmarkup customers. I have argued that competition from alternative markets to provide the investment vehicles which enable these strategies ensures that margin equalization will ultimately fail to achieve this goal as well. —James T. Moser ^ e e m y fo rth c o m in g artic le in Economic Perspectives, J u ly /A u g u s t 1991. 2T h is is b a se d o n a n average v o lu m e o f S u p e rD O T tra d e s o f ju s t over 85% since J a n u a ry 1988. S u p e rD O T tra d e s are h ig h v o lu m e tra d e s w h ich a re m u c h m o re likely to b e p la c e d by in stitu tio n s. IIIS-S2S (ZI£) 06909 s io u in i ‘o § E 3 iq 3 HS Od J3UI33 u o n e u u o j u i ^ y iq n j O D V D IH D J O 3 N V 9 3 A t f 3 S 3 tf 3 V ^ 3 < 3 3 3
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