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mmmm ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO MAY 1988 NUMBER 9 Chicago Fed Letter Setting futures m argins: Who?. . .and how high? Great natural disasters bring in their wake calls for government action to prevent, or at least lessen the impact of, the next occurrence. Earthquakes give rise to construction code changes and evacuation plans; floods, to new levees, dams, and runoff channels. Just so, the global stock market “break” of October 1987 generated many pro posals for change in financial regu lation and practice, designed to reduce the possibility and lessen the effect of another such event. But preventive measures, whether for natural or economic disasters, are not without cost. Some may even be counterproductive. This Letter examines one such proposal—to federally regulate and raise margins on stock index fu tures to bring them in line with mar gins on stocks—and finds that its proponents have yet to make a con vincing case for higher margins on these financial tools. From earlier markets for such com modities as grains and livestock, futures markets have been extended to finan cial instruments in recent years. One of the most widely traded of the finan cial futures contracts, and the one dis cussed here, is the Chicago Mercantile Exchange’s (CME’s) Standard and Poor’s 500 Index contract which began trading in 1982. By 1984, the daily dollar volume of stock index contracts traded on the CME exceeded the daily dollar volume on the New York Stock Exchange, as seen in Figure 1. How ever this does not mean that the futures market has become more important than the stock market. A more rele vant measure of the importance of stock index futures is the underlying value of the contracts outstanding, or open interest. Open interest in stock index futures contracts is a small frac tion of the value of shares outstanding on the New York Stock Exchange—less than 1 percent (Figure 2). At the heart of the economic role of a futures market is risk transfer. Futures contracts provide a way of transferring risk from hedgers who seek to reduce risk to speculators who would bear risk in the hope of profiting by it. Attempts to curb speculative activity on these contracts by raising futures margins overlook the fact that such curbs would also reduce an investor’s ability to sell off unwanted risk by hedging. Those who advocate higher, government-regulated margins on stock index futures, as outlined in the Brady Commission report and The Newr York Stock Exchange Report by Nicholas deB. Katzenbach, make two argu ments. First, stock index futures and their underlying stocks are functionally equivalent instruments with similar 2. Underlying market values percent 2 - •*1 n O pen in te re s t as % of NY SE v a lu e ------ 1 1982 1983 1984 1985 1986 profit and loss characteristics and, for this reason, margins for the two should be harmonized. Second, the current index futures margin, because it is lower than stock margin, promotes un desirable speculative activity. This re sults in excessive stock price volatility and undermines the integrity of the fi nancial system. Harmonizing margins, it is argued, would stabilize prices by curbing speculation. Not all margins are created equal Despite some similarities in the under lying profit and loss characteristics of stocks and futures, futures and equity margins are not identical in purpose or function. Margin on a futures contract is a performance bond posted by both the buyer and seller of the contract and not a downpayment as in the cash market. Margins on futures are only one of many devices that ensure the fi nancial integrity of the markets. Fur ther, the risk of the stock index contract is not the same as the risk of holding an individual corporate stock. These differences warrant lower margins on futures relative to stocks. futures exchanges, that bond is called “margin.” rant different margins on futures contracts. Stocks and apples. A share of stock is an asset, a piece of a corporation. It gives its owner the right to vote on the operation of the corporation as well as a claim to any profits that the corpo ration pays out in the form of divi dends. Investors who buy shares of stock may either pay cash or buy on credit extended by the broker. When investors buy on credit, they must make a downpayment. The minimum downpayment, which changes infrequently,1 is determined by the Federal Reserve. In the parlance of the equities markets, the downpayment is called “margin.” The futures exchanges use margin re quirements to preserve the financial integrity of the market. Unlike stock margins, the level of futures margins is primarily a function of price volatility. Initial margin is set equal to the maxi mum expected one-day price move plus a cushion. The minimum initial specu lative margin (stated in a fixed dollar amount) on the S&P 500 futures con tract is currently $19,000, roughly 15 percent of the total value of the con tract. This is well below margin levels set for stocks. Baskets and eggs. There is an im portant distinction between the type of risk realized by holders of a stock and holders of an S&P 500 futures contract. The risk assumed by holders of an in dividual stock consists of market risk and firm-specific risk. In contrast, in vestors holding a futures contract on the S&P 500 Index realize only the market risk because the firm-specific component has been diversified away. Because less risk is assumed by the holder of an S&P 500 futures contract than by an individual holding equity in a corporation, the S&P 500 futures contract margin requirement should be lower to reflect this. Margin requirements on stocks are 50 percent of the market value of the stock for most investors. Stock margin is less for stock specialists, who are required to post only a maintenance margin, which is set by the New York Stock Exchange at 25 percent. If the amount of margin posted by an investor falls below 25 percent as a result of an ad verse price move, then additional mar gin must be posted to restore the account to its maintenance level. Federally regulated stock margins have been in effect for more than half a cen tury. They are designed to protect in vestors from the risks of highly leveraged positions, to limit the role of credit in destabilizing stock prices, and to prevent the diversion of credit from more productive resources. Futures and oranges. A stock index futures contract is an obligation to buy or sell the cash value of a portfolio of stocks at a future date for a price agreed upon today. It conveys no vot ing rights and pays no dividends. In addition, each party to the contract bears risk and must post a performance bond with a broker who is a member of the exchange on which the contract is traded. The amount of the bond is set by the exchange and can vary as war ranted by market conditions. Brokers may impose higher margins if they wish. The purpose of the bond is to ensure that both parties are able to fulfill their obligations at the expiration of the contract. In the parlance of the Sometimes the value of the futures margin account falls below a certain level, known as the maintenance level. This occurrs when there is an adverse price change. When this happens, the exchange requires that additional mar gin be posted in cash to restore the margin account to its original level. In addition to overall margin levels, other details of margin policies help ensure that market participants fulfill their obligations. First, speculators have higher initial margin require ments than hedgers because hedgers have a cash market position that in creases in value as the futures position declines in value. Second, the daily marking-to-market of positions reduces the default risk to the exchange clear inghouse to a one-day price movement. All margin payments are due prior to the start of the next trading day. This contrasts with the equity market regu lations that require maintenance mar gin payments within seven business days, during which time additional maintenance margin calls could accrue if stock prices continue to fall. Further, the Chicago Mercantile Exchange makes daily intraday margin calls. Market performance is also ensured by position limits that are set by the Commodity Futures Trading Commis sion. The limits are 5000 contracts net short or long per owner. There are no position limits in the stock market. These differences in institutional ar rangements alone are sufficient to war Margins and speculation The second argument is that lower fu tures margins promote undesirable speculative activity, which results in excessive stock market price volatility. This argument makes two important assumptions. First, it assumes that speculative activity in the marketplace is undesirable, and second, it assumes that futures margins are an effective policy tool for limiting speculation and volatility. Is speculation bad? The first as sumption ignores the important role of speculators in futures markets. Speculators absorb the price risk that hedgers do not want to bear. Speculators also increase the ease with which hedgers find trading partners and facilitate continuous price discov ery by assuring that prices are competitively determined by frequent transactions of market participants. Ironically, the single activity that is most frequently cited as exacerbating the market break of October 1987 was portfolio insurance—a dynamic hedging strategy.2 When stock prices are falling, portfolio insurers sell futures contracts to either hedgers or speculators to re duce their exposure to the stock mar ket. Hedgers will buy futures contracts and simultaneously sell the underlying stock, thus locking in a rate of return. Speculators, however, will not offset their futures positions in the stock market, thus keeping sell pressure off the stock market. Data compiled by the Chicago Mercantile Exchange indicate that on October 19 the speculative accounts were net buyers of S&P 500 futures contracts. If these speculators had not been in the market, portfolio insurers would have had to turn to the stock market to execute their strategies. By eliminating speculators, higher margin levels might thus have intensified the price break on October 19.3 Can higher margins reduce spec ulation? Raising futures margins in creases futures market transactions costs.4 The empirical evidence shows that increasing futures margins causes some investors to leave the market, thereby reducing daily volume and open interest.5 However, the evidence does not indicate which investors will leave. Theoretically, traders—either hedgers or speculators—whose price ex pectations are closest to the currently quoted market price will be the first to exit, leaving only those traders whose price expectations diverge most from the market price. This might cause intraday price volatility to rise.6 There is also evidence that increases in margins are not effective in limiting the formation of speculative bubbles. During 1979 and 1980 silver prices rose rapidly. Futures margins were steadily increased to dampen speculative activ ity. However, high margins did little to stem the increase in silver prices.7 Margins appear to have provided no defense against excessive optimism. Conclusion The call for higher, federally regulated futures margins overlooks differences in the purpose and nature of futures and equities, and their margining systems. These differences alone would justify a lower margin on stock index futures contracts. Higher futures margins might be justified if the futures margins set by the exchanges were ineffective in preventing defaults in the futures mar ket. But, the current system of exchange-determined margins served its purpose despite the massive sell-off in October; no CME clearing member defaulted and the financial integrity of the markets was preserved. The selfregulatory bodies responsible for setting margins in the futures markets reacted appropriately by increasing margins when it became apparent that price volatility had increased. Thus, if a case is to be made for re quiring higher margins on stock index futures contracts, it must be based on the desirability of reducing speculation. However, speculative activity in futures markets provides a useful function by allowing investors to shed unwanted risk at reduced cost. Increasing mar gins on futures would increase the cost of speculating in the futures markets, thus interfering with investors’ ability to manage risk. Proponents of higher futures margins have yet to provide evidence linking differential margins on stocks and futures and excessive price movements in the stock market. In creasing futures margins may satisfy the pressures to act in the wake of October’s near financial disaster. Yet this seems an insufficient justification for reducing the investor’s ability to manage risk. liquid assets, leaving less funds available to invest elsewhere. J H a rtz m a rk finds th a t increasing m argin req u irem en ts decreases volum e in the fu tures m arkets. H e also finds th a t increas ing m arg in req u irem en ts decreases the level o f open interest. O th e r studies also address the effects o f m argins on volum e an d open interest. T hese studies are refer enced in his p ap er. 6 See S tephen Figlewski, 1984. “ M argins a n d M a rk e t In teg rity : M arg in S etting for Stock In d ex F u tu res a n d O p tio n s,” Journal o f Futures Markets vol. 4 (Fall), pp. 385-416. 7 See G ary D. K o p p e n h a v er, 1987. “ F u tures M a rk e t R e g u la tio n ,” Economic Per spectives, vol. 11, No. 1 Ja n u a ry /F e b ru a ry : pp. 3-15. — Herbert L. Baer and Maureen V. O ’Neil*2 1 T h e federally reg u lated m inim um initial m arg in re q u irem en t has n o t ch an g ed since 1974. 2 Portfolio in su ran ce activ ity has decreased due to its lim ited effectiveness d u rin g the m ark et break. 3 See J o h n M . H aw ke, B urton M alkiel, M e rto n M iller, an d M y ro n Scholes. Pre liminary Report o f the Committee o f Inquiry Appointed by the Chicago Mercantile Exchange to Examine the Events Surrounding October 19, 1987. C hicago, 1987. 4 See M ichael H a rtz m a rk , 1986. “ T h e Effects o f C h an g in g M a rg in Levels on F u tures M a rk e t A ctivity, the C om position o f T ra d e rs in the M ark e t, a n d Price P e r fo rm an ce,” Journal o f Business, vol. 59, No. 2, pp. 147-180. H a rtz m a rk contends th a t a lth o u g h m arg in can be posted in the form o f T re a su ry Bills, the o p p o rtu n ity cost is not zero. His a rg u m e n t is th a t the investor incurs costs associated w ith the risk th a t he will be c a u g h t short o f liquid assets and, therefore, m ay have to hold ad d itio n al K arl A. Scheld, Senior Vice P resident and D irector of R esearch; David R. A llardice, Vice President and Assistant D irector of R esearch; E dw ard G. Nash, E ditor. C hicago Fed L etter is published m onthly by the R esearch D ep artm en t o f the F ederal Reserve Bank o f C hicago. T h e views expressed are the a u th o rs’ and are not necessarily those of the Federal Reserve Bank o f C hicago or the Federal Reserve System. Articles may be rep rin ted if the source is credited and the Research D ep artm en t is provided with copies of the reprints. Chicago Fed L etter is available w ithout charge from the Public Inform ation C enter, Federal Reserve Bank of Chicago, P.O . Box 834, Chicago, Illinois 60690, or telephone (312) 322-51 11. ISSN 0895-0164 ; Industrial production of manufactured goods nationally edged up 0.2 percent in February. Thus far, the first quarter has been advancing at less than half the pace set in the fourth quarter of 1987. Business equipment continues to be strong, but most durable-goods industries are weak. Transportation equipment and primary metals particularly have been running below their fourth-quarter levels. Manufacturing activity in the Midwest also rose only 0.2 percent in February, following a pattern similar to the nation’s. A notable exception was the continued improvement in primary metals. Data revisions of both labor and capital inputs reversed declines in the previous two months. The revised data show the MMI outpacing the nation since December, continuing its strong 1987 performance. Chicago Fed Letter F E D E R A L R E S E R V E BAN K O F C H IC A G O P u b lic In fo rm a tio n C en ter P .O . Box 834 C h ica g o , Illin o is 60690 (312) 322-5111 N O T E : T h e M M I is a com posite index o f 17 m an u factu rin g industries and is constructed from a w eighted com bination o f m onthly hours worked and kilow att hours d a ta . See “ M idw est M a n u facturing Index: T h e C hicago F ed ’s new regional econom ic in d ic a to r,” Economic Perspectives, F ederal Reserve Bank o f C hicago, Vol. X I, No. 5, S ep tem b er/O cto b er, 1987. T h e U n ited States represents the F ederal R eserve B o ard ’s In d ex o f In d u strial P roduction, M anufactu rin g .
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