A research project that looks at various ways of predicting volatility and setting margin levels in futures markets provides practical solutions that meet the needs of investors and clearinghouses. Around the world, futures exchanges have clearinghouses that play a central role in these markets. Most notably, a futures clearinghouse facilitates trade by eliminating counterparty risk and guaranteeing the integrity of the contracts.
As the originator of the margin setting system currently used by the Hong Kong Futures Exchange, Lam Kin, Hong Kong Baptist University chair professor at the Department of Finance and Decision Sciences said accurate volatility forecasting is a core task in risk management and setting margin levels. "With good evaluation and margin setting systems in place, in the long run investors benefit through paying less while the clearinghouse maintain an adequate amount of risk control," said Professor Lam, a former director of the Hong Kong Clearing Futures Corporation, a subsidiary of the Hong Kong Futures Exchange.
Professor Lam's project, the second he has undertaken using Research Grants Council (RGC) funding, focuses on building a theoretical model for margin setting and to recommend methods of predicting volatility and setting margins. For instance, the professor carefully examined why under his proposed theoretical framework, Exponentially Weighted Moving Average (EWMA), which places emphasis on recent observations works better compared to putting equal weights on historical observations.
One important finding in this project is that implied volatility serves as a very efficient volatility forecast. In the past, the use of implied volatility in margin design has been greatly ignored. The use of implied volatility has an advantage of minimizing the number of changes in margin required by a clearinghouse.
Acting on Professor Lam's research and recommendation, the Hong Kong Futures Exchange adopted the EWMA system 10 years ago during the Asian financial crises, a system the exchange continues to use today. His research findings have been published in the Journal of Futures and Markets, one of the few journals specialising in futures markets. The Professor has also presented his findings at statistical and business conferences.