Futures-market exchanges guarantee the performance of all contracts
to encourage active trading between anonymous partners. Traders buy
from or sell to the clearinghouse. The exchanges rely primarily on a
margin system — traders post a performance bond that they forfeit if
they default — to manage their risk exposure. The market
value of the performance guarantee is the amount a trader would have to pay to
insure his performance if there were no exchange guarantee. An
underpriced guarantee subsidizes high-risk traders and ultimately
undermines the credibility of the exchange's commitment to perform.
An adequate margin policy fairly prices the exchange performance
guarantee within an (economically insignificant)
varepsilon
neighborhood. I show that the value of a call (put) option with a
strike price equal to the futures price minus (plus) the margin is an
upper bound to the market value of the exchange's performance
guarantee. The probability that the futures price change exceeds the
margin is the probability that the option
expires “in the money.” I
estimate the value of the option on the December S&P 500 futures
contract during the market crash in October 1987 to illustrate the
technique. For the first half of the month the value of the
performance guarantee was fairly priced. On the day of the crash it
was underpriced by as much as 10% of the value of the futures
contract. Futures-market margin committees moved quickly; by the end
of the month the value of the performance
guarantee was fairly priced.