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

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  • Radoslav Raykov

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.

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  • Radoslav Raykov, 2024. "Is This Normal? The Cost of Assuming that Derivatives Have Normal Returns," Staff Working Papers 24-46, Bank of Canada.
    • Handle: RePEc:bca:bocawp:24-46
    DOI: 10.34989/swp-2024-46
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    References listed on IDEAS

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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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