Margins, Liquidity, and the Cost of Hedging

12 Pages Posted: 5 Apr 2013

See all articles by Antonio S. Mello

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking

John E. Parsons

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: Winter 2013

Abstract

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.

Suggested Citation

Mello, Antonio S. and Parsons, John E., Margins, Liquidity, and the Cost of Hedging (Winter 2013). Journal of Applied Corporate Finance, Vol. 25, Issue 1, pp. 34-43, 2013, Available at SSRN: https://ssrn.com/abstract=2245433 or http://dx.doi.org/10.1111/j.1745-6622.2013.12004.x

Antonio S. Mello (Contact Author)

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

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Madison, WI 53706
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John E. Parsons

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Cambridge, MA 02142
United States

HOME PAGE: http://www.mit.edu/~jparsons/

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