Studies on Margin Procyclicality - the Impact of Volatility Persistence and Nonlinear Payoffs

We propose to study the procyclical properties of margin requirements in derivative markets. Margin requirements serve as a buffer against the transmission of lossesthrough the financial system by protecting one party to a contract against default by theother party. As is often noted, collateral coverts counterparty risk into funding liquidityrisk through margin call. If margins are based on risk-sensitive rules, however, financialmarkets can be unstable. Margin calls would occur at worst times when markets are inmost stress. A sudden request of billion dollar liquidity is seismic for any bank.Procyclical margin therefore becomes a serious concern of regulators and internationalstandard-setting bodies. What is the root cause of margin procyclicality? How to setrules to mitigate it? What are the chances a given margin level will be breached? Couldmargins of nonlinear assets be more procyclical than linear ones? These are thequestions we plan to address in this proposal. At the center of our proposal is to realizethat volatility persistence and the self-exciting nature of price changes cause extremenegative returns to be serially dependent, which in turn renders margin requirementprocyclical. The alternative we propose is to set "through the cycle" margin levels thatare less sensitive to current conditions and therefore less prone to spikes at the onset ofmarket stress. How much higher a stable margin requirement could be depends on howmuch heavier the unconditional tails of risk factors are, relative to their conditionalcounterparts. How much more collateral one party needs to raise than the other partydepends on how asymmetric the contract's payoff function is.