Extreme Events in Finance

Chapter 16Margin Setting and Extreme Value Theory

John Cotter¹ and Kevin Dowd²

¹UCD School of Business, University College Dublin, Dublin, Ireland

²Economics and Finance, Durham University Business School, Durham, United Kingdom

AMS 2000 subject classification. Primary 62G32, 62E20; Secondary 65C05.

16.1 Introduction

This chapter outlines some key issues in the modeling of futures margins using extreme value theory (EVT). We examine its application in the context of setting initial futures margins. There is a developing volume of literature that examines using EVT in setting margins, and this study provides an overview of the key issues that have been examined.¹ The chapter illustrates how EVT can be a useful approach in the setting of margins with examples for a set of stock index futures.

The successful operation of futures exchanges for the relevant stakeholders such as traders and the exchange necessitates that there be a tradeoff between optimizing liquidity and prudence.² The imposition of margins is the mechanism by which these objectives are met.³ Margin requirements act as collateral that investors are required to pay to reduce default risk. Default risk is incurred if the effect of the futures price change is at such a level that the investor's margin does not cover it, leading to nonpayment by one of the parties to the contract.⁴ Margin committees face a dilemma, however, in determining the magnitude of the margin requirement imposed on futures traders. On one hand, ...