Operations Management and Econometrics

Why April 2007 Triggered October 2008

Dr Vadim Timkovsky, The University of Sydney Business School

28th Apr 2011  - Room 498, Merewether Building

Current margin calculation practice uses two approaches to margining investment portfolios, strategy-based and risk-based. Our observations of the margin rules changes against the margin debt behaviour in the U.S. in the period from 2003 through 2008 support the thesis that the use of the risk-based approach to margining customer accounts with positions in stocks and stock options since April 2007 influenced and triggered the U.S. stock market crash in October 2008. This paper also presents mathematical models showing that the strategy-based approach is, at this point, the most appropriate one for margining security portfolios in customer margin accounts, while the risk-based approach can work efficiently for margining only index portfolios in customer margin accounts and inventory portfolios of brokers. We also show that the application of the risk-based approach to security portfolios in customer margin accounts is very risky and can result in the pyramid of debt in the bullish market and the pyramid of loss in the bearish market. We also provide recommendations on ways to set appropriate margin requirements.