Determining margin for futures contracts: the role of private interests and the relevance of excess volatility

This article examines the relation between volatility and margin levels in order to assess the plausibility of the Excess Volatility Argument and the Prudential Exchange Hypothesis. The next section discusses the private interests involved in setting margin levels and their relevance to the justification of the Prudential Exchange Hypothesis. The Excess Volatility Argument is critiqued in the following section. Analysis of the theory underlying the Excess Volatility Argument, a review of existing evidence on the links between margin and volatility, and new tests of the theory all fail to support the proposition that raising margins leads to reductions in volatility. Evidence for the Prudential Exchange Hypothesis is mixed. Tests relating margin changes to previous levels of volatility fail to confirm the hypothesis. A cross-sectional approach to test this hypothesis is introduced and some preliminary results are reported. Conclusions concerning the Prudential Hypothesis and the Excess Volatility Argument are summarized in the last section of the article.