Is This Normal? The Cost of Assuming that Derivatives Have Normal Returns

Radoslav Raykov

Staff Working Papers from Bank of Canada

Abstract: Derivatives exchanges often determine collateral requirements, which are fundamental to market safety, with dated risk models assuming normal returns. However, derivatives returns are heavy-tailed, which leads to the systematic under-collection of collateral (margin). This paper uses extreme value theory (EVT) to evaluate the cost of this margin inadequacy to market participants in the event of default. I find that the Canadian futures market was under-margined by about $1.6 billion during the Great Financial Crisis, and that the default of the highest-impact participant generates a cost of up to $302 million to be absorbed by surviving participants. I show that this cost can consume the market’s entire default fund and result in costly risk mutualization. I advocate for the adoption of EVT as a benchmarking tool and argue that the regulation of exchanges should be revised for financial products with heavy tails.

Keywords: Financial institutions; Financial stability (search for similar items in EconPapers)
JEL-codes: G10 G11 G20 (search for similar items in EconPapers)
Pages: 45 pages
Date: 2024-11
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:24-46

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