VALUING THE FUTURES-MARKET PERFORMANCE GUARANTEE

Abstract

Futures-market exchanges guarantee the performance of all contracts to encourage active trading between anonymous partners. Traders buy from or sell to the clearinghouse. The exchanges rely primarily on a margin system — traders post a performance bond that they forfeit if they default — to manage their risk exposure. The market value of the performance guarantee is the amount a trader would have to pay to insure his performance if there were no exchange guarantee. An underpriced guarantee subsidizes high-risk traders and ultimately undermines the credibility of the exchange's commitment to perform. An adequate margin policy fairly prices the exchange performance guarantee within an (economically insignificant) varepsilon neighborhood. I show that the value of a call (put) option with a strike price equal to the futures price minus (plus) the margin is an upper bound to the market value of the exchange's performance guarantee. The probability that the futures price change exceeds the margin is the probability that the option expires “in the money.” I estimate the value of the option on the December S&P 500 futures contract during the market crash in October 1987 to illustrate the technique. For the first half of the month the value of the performance guarantee was fairly priced. On the day of the crash it was underpriced by as much as 10% of the value of the futures contract. Futures-market margin committees moved quickly; by the end of the month the value of the performance guarantee was fairly priced.