A stochastic process approach in setting the appropriate margin level for the TAIFEX stock index futures

Purpose – The main purpose of this paper is to compute the appropriate margin level for the stock index futures traded on the Taiwan Futures Exchange (TAIFEX) and, then, to examine the appropriateness of the real margin requirement set by the TAIFEX. Design/methodology/approach – This paper develops a new approach assuming the future's prices follow a geometric Brownian motion process. Compared with the extreme value theory that has been intensively used to determine the appropriate futures margin levels, one of the advantages of the present model is no need to specify the frequency at which extremes are taken. Findings – The evidences indicate that the theoretical margins obtained by the proposed model can provide a more accurate and flexible margin level in accordance with the market volatility. Research limitations/implications – The main limitation of this approach is that the natural logarithm of the futures prices is assumed to follow a Brownian motion process. However, such an assumption might not be practical for financial returns. Practical implications – The research is helpful for the clearinghouse to set up its margins policy, especially under various conditions of volatility risks. Originality/value – This paper proposes a theoretical procedure to set an appropriate futures margin for the TAIFEX. This paper also provides a better understanding of Taiwan's futures market that is newly launched and is useful for investors to hedge and speculate.