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Valuing the Futures Market Clearinghouse's Default Exposure During the 1987 Crash

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  • David Bates
  • Roger Craine
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    Abstract

    Futures market clearinghouses are intermediaries that make large volume trading between anonymous parties feasible. During the October 1987 market crash rumors spread that a major clearinghouse might fail. This paper presents estimates of three measures of the default exposure on the popular S&P500 futures contract traded on the Chicago Mercantile Exchange. We estimate the traditional summary statistic for risk exposure: the tail probabilities that the change in the futures price exceeds the margin. And we estimate two economic measures of the risk--the expected value of the payoffs in the tails and expected value of the payoffs in the tails conditional on landing in the tail. The economic measures of risk reveal exposure from low probability large payoff events--like a crash--that does not show up tail probabilities. The tail probabilities only capture the likelihood of a crash, not the expected loss. The estimated measures of risk follow directly from estimates of the conditional distribution of futures price changes. We infer a jump-diffusion process and a log-normal rocess from the prices of traded options and we estimate a jump-diffusion process from time-series data on futures prices. After the crash the forward-looking jump-diffusion model inferred from traded options reflects the fears of another crash voiced by market participants. The model indicates another jump is unlikely, but if it occurred it would be big and negative. The tail probabilities are small, less than 2%. But, the day after the crash the model estimates the expected value of payoffs in the tails conditional on landing in the tail equals of 55% of the S&P500 futures price. According to this estimate roughly $10.5 billion in liquid reserves would be required to weather another crash. On October 20 the Federal Reserve announced it stood ready to supply the necessary liquidity.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6505.

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    Date of creation: Apr 1998
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    Publication status: published as Journal of Money, Credit and Banking, Vol. 31, no. 2 (1999): 248-272.
    Handle: RePEc:nbr:nberwo:6505

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    1. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-20, June.
    2. Lamoureux, Christopher G & Lastrapes, William D, 1993. "Forecasting Stock-Return Variance: Toward an Understanding of Stochastic Implied Volatilities," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 293-326.
    3. Craine, Roger, 1995. " Fairly Priced Deposit Insurance and Bank Charter Policy," Journal of Finance, American Finance Association, vol. 50(5), pages 1735-46, December.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    5. Roger Craine., 1992. "Are Futures Margins Adequate?," Economics Working Papers 92-192, University of California at Berkeley.
    6. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
    7. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    8. Bernanke, Ben S, 1990. "Clearing and Settlement during the Crash," Review of Financial Studies, Society for Financial Studies, vol. 3(1), pages 133-51.
    9. Garman, Mark B & Klass, Michael J, 1980. "On the Estimation of Security Price Volatilities from Historical Data," The Journal of Business, University of Chicago Press, vol. 53(1), pages 67-78, January.
    10. Craine, Roger, 1995. "Fairly Priced Deposit Insurance and Bank Charter Policy," Department of Economics, Working Paper Series qt6dv142sd, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    11. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De.
    12. Roger Craine., 1995. "Fairly Priced Deposit Insurance and Bank Charter Policy," Economics Working Papers 95-234, University of California at Berkeley.
    13. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-70, March.
    14. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    15. Mark J. Warshawsky & Earnhart Dietrich & assistant, 1989. "The adequacy and consistency of margin requirements in the markets for stocks and derivative products," Staff Studies 158, Board of Governors of the Federal Reserve System (U.S.).
    16. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    17. Bates, David S, 1991. " The Crash of '87: Was It Expected? The Evidence from Options Markets," Journal of Finance, American Finance Association, vol. 46(3), pages 1009-44, July.
    18. Parkinson, Michael, 1980. "The Extreme Value Method for Estimating the Variance of the Rate of Return," The Journal of Business, University of Chicago Press, vol. 53(1), pages 61-65, January.
    19. Lo, Andrew W., 1986. "Statistical tests of contingent-claims asset-pricing models : A new methodology," Journal of Financial Economics, Elsevier, vol. 17(1), pages 143-173, September.
    20. Robert F. Engle & Alex Kane & Jaesun Noh, 1993. "Index-Option Pricing with Stochastic Volatility and the Value of Accurate Variance Forecasts," NBER Working Papers 4519, National Bureau of Economic Research, Inc.
    21. Craine, Roger, 1992. "Are Futures Margins Adequate?," Department of Economics, Working Paper Series qt30c296g3, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    22. David S. Bates, 1997. "Post-'87 Crash Fears in S&P 500 Futures Options," NBER Working Papers 5894, National Bureau of Economic Research, Inc.
    23. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
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