Issue 16, February 2009

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Postgraduate Research Fellowship Scheme
Risk Management and Corporate Governance Practices of Listed Chinese Companies
Modeling Default Correlation Using Credit Contagion Approach
Margin Setting Methodologies Under a Constraint of
Change Frequencies
A Longitudinal Study of Parental Control in Early Adolescence in
Hong Kong
Demographic Analysis of Healthy Longevity in China
Chess for those Playing From The Heart
RGC Public Lectures - Cancer Research

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.

Professor Lam said the margin system is the first line of defense against the default risk of a clearinghouse. From the perspectives of a clearinghouse, the major concern is to have a prudential system to control the default exposure. Once the level of prudentially is set, the next concern will be the opportunity cost of the investors, because high opportunity cost discourages people from hedging futures, and thus defeats the function of a futures market.

"While there are no crystal ball processes for predicting futures market volatility, measuring systems and theoretical models can help to set margins to protect both clearing houses and investor interests," said Professor Lam. He said margin settings cover the up-front payment investor's need to make to guarantee they will fulfill their duties when they purchase a futures contract.

The Professor's research project focuses on a method of setting margins in a futures market that can control both the coverage probability as well as the expected frequency of margin changes during the course of a year. While the coverage probability takes care of the risk exposure of the exchange, the frequency of margin changes protects investors from sudden changes in margin requirements.

"The aim of the project is to improve on the present system by developing an optimal margin design in such a way that investors' interests are optimised without loosening exchange's risk control," said Professor Lam. "This is made possible by trying out various volatility forecasts using minute-by-minute clearinghouse data," he added.

Professor Lam Kin
Department of Finance and Decision Sciences
Hong Kong Baptist University