University of Technology, Sydney

Regulatory Tools and Price Changes in Futures Markets

Email address: paul.kofman@uts.edu.au

Keywords: price limits, margin setting, learning

JEL Classifications: G00

Abstract:
There is an extant literature investigating the relation between futures price limits and the volatility of futures price changes. An equally impressive number of papers investigates margin levels and their relation with price volatility. Very few papers explicitly model the indirect relation, through volatility, between margins and limits. Brennan's (1986) model is the only exception. In his model, price limits help control contract default risk, therefore reduce required margins and ultimately lead to lower cost of transacting. The crucial assumption in Brennan's model is the absence of accurate price signals when prices are locked at the limit. We extend Brennan's model with more realistic price change distributions that capture typical characteristics like fat tails and time-varying volatility. We also discuss how learning can occur and how this may affect cost minimizing optimality of regulation.

PDF file of paper: kofman.pdf

Session: Volatilities

Time: Friday, 6 July, 8:45am - 10:15am

Room: A