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May 16, 2014

Procyclicality of Risk Based Initial Margin Models | Bank of England Research

The Bank of England have published a study into the way IM models work when reacting to stressed market conditions, comparing models such as VaR, Historic Simular VaR and HSVaR with an Exponentially Weighted Moving Average (EWMA) filter.

The Bank of England have published a study into the way IM models work when reacting to stressed market conditions, comparing models such as VaR, Historic Simular VaR and HSVaR with an Exponentially Weighted Moving Average (EWMA) filter. The BoE introduction says:

The initial margin requirements for a portfolio of derivatives are typically calculated using a risk model. Common risk models are procyclical: margin requirements for the same portfolio are higher in times of market stress and lower in calm markets. This procyclicality can cause liquidity stress whereby parties posting margin have to find additional liquid assets, often at just the times when it is most difficult for them to do so. Hence regulation has recognised that, subject to being adequately risk sensitive, margin models should not be ‘overly’ procyclical. There is, however, no standard definition of procyclicality.
 
This paper proposes two types of quantitative measure of procyclicality: one that examines margin variation across the cycle and one that focuses on short-term margin increases. It then studies, using historical and simulated data, various margin models with regard to both their risk sensitivity and the proposed procyclicality measures. It finds that models which pass common risk sensitivity tests can have very different levels of procyclicality.
 
The paper recommends that CCPs and major dealers should disclose the procyclicality properties of their margin models, perhaps by reporting the proposed procyclicality measures. This would help derivatives users to anticipate potential margin calls and ensure they have adequate holdings of or access to liquid assets.
CCPs positively advertise that their IM models will react to a sudden change in market conditions – otherwise they aren't protecting themselves when a crisis occurs. What isn't obvious is how that reaction to current market conditions, contributes back into the market conditions and potentially makes a bad situation worse. The study of this area is exactly the sort of systemic risk that CCPs are intended to mitigate, but yet may also contribute to instead.
 
Source: http://www.bankofengland.co.uk/research/Pages/fspapers/fs_paper29.aspx, and the paper is attached below also.

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