Setting futures margins: the extremes approach

Using a cost minimizing approach it can be shown that futures margins are set optimally when the cost rate induced by the margin equals the probability of default. Empirically this implies that extreme value analysis should be used since cost rates are, most likely, very small. Application of this approach to NYSE composite futures for the period 1982-1990 shows that actual margins are too invariable and too low, especially before the stock market crash of October 1987.