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Margins, Liquidity, and the Cost of Hedging
Author(s) -
Mello Antonio S.,
Parsons John E.
Publication year - 2013
Publication title -
journal of applied corporate finance
Language(s) - English
Resource type - Journals
eISSN - 1745-6622
pISSN - 1078-1196
DOI - 10.1111/j.1745-6622.2013.12004.x
Subject(s) - mandate , derivative (finance) , derivatives market , market liquidity , margin (machine learning) , hedge , clearing , counterparty , business , economics , credit risk , capital requirement , capital (architecture) , finance , monetary economics , incentive , futures contract , microeconomics , computer science , history , ecology , archaeology , machine learning , political science , law , biology
Recent financial reforms, such as the Dodd‐Frank Act in the U.S. and the European Market Infrastructure Regulation, encourage greater use of clearing and therefore increased margining of derivative trades. They also impose margining requirements on noncleared derivative trades. Such requirements have sparked a debate about whether a margin mandate increases the cost of hedging by nonfinancial corporations—the so‐called end‐users of derivatives. The authors argue that it does not. They show that a nonmargined derivative is equivalent to a package of (1) a margined derivative and (2) a contingent line of credit. The main effect of a margin mandate is to require that this package be marketed as two distinct products. But it does not change the total financing or capital required to hedge. Nor does it raise the cost to banks or other dealers of offering the package, at least not directly. Nevertheless, there may be indirect effects if, for example, the clearing mandate succeeds in lowering total counterparty exposures and therefore systemic risk. Although the authors do not explore these effects, they do offer one explanation for the popularity of over‐the‐counter, and thus noncleared, derivatives: accounting rules and bank regulations that treat the implicit lines‐of‐credit embedded in nonmargined derivatives differently from explicit lines of credit used to fund margins.