Dynamic margin setting with EWMA volatilities

Abstract

The optimal clearing margin levels are crucial for default risk management system of a clearing house. The margin levels must be conservatively high enough to provide financial protection in the default loss event, but not too high to cause market liquidity problem. A static margin setting can result in a margin level which is too high. This paper proposes a dynamic margin setting model and methodology based on value-at-risk with simulated exponentially weighted moving average (EWMA) volatilities. The EWMA model gives the largest weight to the most recent innovation, which makes the dynamic setting of the margin levels more plausible. Based on the worst-case-scenario approach, the optimal margin levels can be set by choosing the model parameters as their maximum values from across different historical periods. The back test shows that the margin setting model is not sensitive to any chosen sample period. Both optimal margin level and back test can be run on a daily basis.