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Margin Requirements Across Equity-Related Instruments: How Level Is the Playing Field?

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Margin Requirements Across Equity-Related Instruments: How Level Is the Playing Field? Fortune pgs 31-50 1/6/04 8:21 PM Page 31 Margin Requirements Across Equity-Related Instruments: How Level Is the Playing Field? hen interest rates rose sharply in 1994, a number of derivatives- related failures occurred, prominent among them the bankrupt- cy of Orange County, California, which had invested heavily in W 1 structured notes called “inverse floaters.” These events led to vigorous public discussion about the links between derivative securities and finan- cial stability, as well as about the potential role of new regulation. In an effort to clarify the issues, the Federal Reserve Bank of Boston sponsored an educational forum in which the risks and risk management of deriva- tive securities were discussed by a range of interested parties: academics; lawmakers and regulators; experts from nonfinancial corporations, investment and commercial banks, and pension funds; and issuers of securities. The Bank published a summary of the presentations in Minehan and Simons (1995). In the keynote address, Harvard Business School Professor Jay Light noted that there are at least 11 ways that investors can participate in the returns on the Standard and Poor’s 500 composite index (see Box 1). Professor Light pointed out that these alternatives exist because they dif- Peter Fortune fer in a variety of important respects: Some carry higher transaction costs; others might have higher margin requirements; still others might differ in tax treatment or in regulatory restraints. The author is Senior Economist and The purpose of the present study is to assess one dimension of those Advisor to the Director of Research at differences—margin requirements. The adoption of different margin the Federal Reserve Bank of Boston. He requirements for otherwise identical risk and reward positions might cre- is grateful to Michelle Barnes, Jeffrey ate an uneven playing field that shifts traders and investors from high- Fuhrer, and Richard Kopcke for con- margin to low-margin instruments as they seek greater leverage or lower structive comments. carrying costs. This can result in inefficient trading, as when traders pay Fortune pgs 31-50 1/6/04 8:21 PM Page 32 Box 1 Eleven Ways to Buy the S&P 500 Index • Purchase every one of the 500 stocks in the index; • Buy from a Wall Street dealer a structured note with an interest rate tied to the return on the S&P 500; • Buy one of a number of futures contracts trading on the S&P 500; • Buy from a bank an equity-linked Certificate of Deposit that would pay a guaranteed minimum • Negotiate a forward contract on the index with a rate, but if the S&P 500 increased over a certain private intermediary, such as an investment bank; level, the interest rate would be tied to that increase; • Buy a call option on the S&P 500, which would • Buy a Guaranteed Investment Contract with the allow one to capture the capital gains on the S&P same linkage from a life insurance company; 500, should prices rise; • Enter into an equity swap where one would pay a • Buy the 500 stocks in the index and a put option, floating interest rate (usually the London Interbank yielding the same result as buying a call option, Offered Rate, known as LIBOR) and receive the rate namely, ensuring against a drop in the price of the of return on the S&P 500; or index while allowing one to benefit from a rise in its price; • Buy a unit investment trust that holds the S&P 500; an example is a SPDR, traded on the American • Buy a bond convertible into the S&P 500 at face Stock Exchange. value; Source: Professor Jay Light, as quoted in Minehan and Simons (1995), p. 6. higher trading costs in order to gain the benefit of assess, for each of the strategies identified in Section II, lower margin requirements, and it can reduce the abil- the costs of margin requirements. This allows judg- ity of financial agents to distribute risks in a way that ments about the relative effects of differential margin minimizes financial volatility. requirements. This study focuses on equity-related instruments: Our primary conclusion is that the playing field stocks, stock index instruments, stock options, stock is more level than a cursory focus on initial margin index options, futures on stocks and stock indexes, requirements might indicate. We find that the costs and options on those futures. Section I provides back- associated with margin requirements on equities or ground on these financial instruments and on the mar- stock indexes—costs embedded in the Federal kets in which they are traded. Section II demonstrates Reserve Board’s Regulation T—are essentially fixed that, in the absence of margin requirements, strategies costs: Only in the event of extreme price declines using options, futures, and options on futures can do maintenance margin calls occur; Regulation T’s duplicate the returns on a leveraged purchase of initial margins are typically the sole source of mar- stocks or a stock index. Though these strategies are gin-related trading cost. On the other hand, costs of shown to be identical in their risks and returns, differ- margin requirements on derivatives, particularly on ences in margin requirements might create incentives futures contracts, have a low fixed cost component to prefer one strategy over others. but are more sensitive to the price of the underlying Section III provides a background for understand- security: While maintenance margins on equities ing margin requirements in stocks, options, futures, rarely come into play, the practice of requiring varia- and futures options. This is essential to the modeling tion margin on derivatives induces highly variable of margin requirements on each of the replicating port- costs. folios discussed in Section II. Section IV develops a model to simulate the values arising from several 1 These notes paid an interest rate that fell when the general level of interest rates increased, exposing the county to revenue identical positions obtained by combinations of stocks shortfalls that threatened its ability to meet its obligations, as well as and stock derivatives. The results are then used to to capital losses on the notes. 32 2003 Issue New England Economic Review Fortune pgs 31-50 1/6/04 8:21 PM Page 33 In short, players in the different markets might dealers belonging to the Put and Call Dealers not select their instruments on the basis of initial mar- Association. Because options contracts were written gins, and the differences in average costs, though sig- directly between buyer and seller, counterparty risk nificant, might not be the primary reason to choose (the risk that the other party would fail to perform) one instrument over others. Rather, investors and was high. And because the contracts were not stan- traders might be motivated by a choice between fixed dardized, they were illiquid and not easily resold. To and variable margin costs: Risk-tolerant investors remedy these problems, the Chicago Board Options choose instruments with high variable and low fixed Exchange (CBOE) was formed in 1973 to trade equity costs, such as futures or options, while less risk-toler- options (options on individual stocks). The CBOE pro- ant investors select instruments with low variable but vided standardized contracts and established a clear- high fixed costs. Rather than the playing field being inghouse that guaranteed the performance of con- uneven, each instrument might be traded on a differ- tracts, thereby shifting the counterparty risk from the ent playing field. buyer and seller to clearinghouse members. These Caveats are in order. This study does not address innovations mitigated counterparty risk and enhanced the effects of other factors affecting an investor’s deci- liquidity by allowing exchange-traded options posi- sion about which markets to use to achieve a path of tions to be easily reversed by offsetting trades: A hold- financial returns; among these other factors are com- er (writer) of a standardized call option could sell missions and fees, taxes, and regulatory or legal (buy) an identical call option, thereby neutralizing his restrictions. It is also based on a small subset of equity- position. The counterparty risk taken by the CBOE related instruments traded on registered exchanges; clearinghouse led it to establish initial and mainte- over-the-counter (OTC) instruments, which have no nance margin requirements to protect itself from fail- standardized margin-related costs, are not considered. ure of its clearing members. Finally, the analysis is based on simulations of prices In 1982, the CBOE initiated trading in put and call following standard pricing models with random options on the S&P 100 stock index option, the first return-generating processes. While this incorporates stock index option traded in the United States. In 1993, known aspects of the probability distribution of the CBOE began trading S&P 500 Depository Receipts returns on common stocks, the results cannot be gen- (“Spiders”), the first Exchange Traded Fund (ETF), eralized to specific portfolios in specific periods, nor and options on Spiders. A popular way to mimic the can they be applied to conditions of extreme financial S&P 500 index, Spiders differ from open-end mutual duress, during which probability distributions might funds, such as Vanguard’s S&P 500 Index Fund, in sev- be different from the norm. eral important ways: They (and other ETFs) are traded continuously throughout the day, they can be sold short, and they can sell at a premium or discount to net 2 I. Equity-Related Financial Instruments asset value. Both equity options and options on ETFs, which According to Ritchken (1987), organized trading trade like stocks, are American-style, meaning that in stock options began in London in the eighteenth they can be exercised at any time up to the expiration century.
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