Excessive Margin Requirements and Intermarket Derivative Exchange Competition: A Study of the Effect of Risk Management on Market Microstructure

The S&P 500 Index futures contract is traded on the Chicago Mercantile Exchange that isregulated by the Commodity Futures Trading Commission. The S&P 500 Index optionscontract is traded on the Chicago Board of Options Exchange that is regulated by theSecurities and Exchange Commission. The differing regulatory structures have led to theS&P 500 Index futures and options contracts being subject to differing customermargining (collateral) requirements. Generally, S&P 500 Index options customermargin requirements are higher than their futures counterpart for a comparably leveragedposition. This dissertation examines whether higher relative margin costs lead to tradersubstitution between markets such that margin costs help determine relative market share.The empirical result I find is that margin costs do not appear to affect market sharebetween options and futures markets. This result may not necessarily be a rejection ofeconomic theory that suggests traders will substitute between like assets based ondifferences in these assets’ costs, but may result from large illiquidity in options marketsas characterized by the empirical finding of relatively large bid ask spreads in optionsmarkets for similarly leveraged positions. The finding of relatively large bid ask spreadcosts in the S&P 500 options market is consistent with the academic literature findingthat price discovery occurs primarily in the futures market ( Fleming, Ostdiek andWhaley (1996)).