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The impact on the futures industry

Arbitrage conditions in the futures markets deteriorated during the crisis. Daily volatility took off towards unprecedented levels in the three main markets (stock market index, interest rates and foreign exchange). Ibovespa futures had their basis squeezed and, after October 30th, suffered the interest rate hike as a doubling of their cost-of-carry. US dollar futures, on the other hand, had a widened basis throughout the crisis. In all markets, the open interest also increased. All these effects posed a challenge to the risk management system at the Brazilian Futures Exchange. In the following sections, some of the measures taken are discussed.

Risk management procedures at the Brazilian Futures Exchange (BM&F)
BM&F nowadays sets its margin requirements based on estimates of covariance matrices of the most liquid futures contracts, namely: interbank deposits average interest rate, from the closest up to the sixth maturity; US$ exchange rate, from the closest up to the fourth maturity; and the closest maturity of Ibovespa futures contracts. The Value-at-Risk methodology used by the exchange was appraised by a panel of risk managers from private banks.
Volatilities and correlations are estimated through exponentially weighted moving averages of the historical returns. The methodology closely follows the RiskMetrics standard, widely applied throughout Brazilian institutions. Periodical backtesting is done over the matrices estimates.

Margin calls in the major contracts (interest rate,  US$ and Ibovespa futures)
Right before the outbreak of the crisis in October, BM&F clearing house worked under the hypotheses of an eventual increase in the volatility of foreign exchange futures contracts. Therefore margin requirements for these contracts, although evaluated as a function of historical volatility, already incorporated a premium for the possibility of a currency devaluation.
On the other hand, interest rate and Ibovespa futures’ margin requirements suffered substantial increases during the crisis. The establishment of circuit-breakers reduced the total volume of index futures mark-to-market settlements in the first days of the crisis. Interest rates futures contracts, however, caused more aprehension among BM&F officials. Their risk management system estimated very low volatilities for this market, reflecting the steadily decreasing interest rates policy of the Brazilian government. Nevertheless, there was no instance of default registered by the clearing house, although some less-than-orthodox settlement arrangements were made (e.g., the use of opposite positions with differing maturities). As far as additional margin requirements are concerned, payments were managed in a case-by-case basis, and aproximately 10 cases demanded special payment arrangements. See the table below for the change in margin requirements since the beginning of the crisis.


Margin requirements as a percentage of notional value

US$ futures Interest rate futures Ibovespa futures
Expiration 24-10-97 2-03-98 24-10-97 2-03-98 24-10-97 2-03-98
1st 1.32 10.85 0.06 1.36 8.33 15.37
2nd 2.20 10.85 0.18 2.71 no liqdty. no liqdty.
3rd 3.08 10.85 0.38 3.17 no liqdty. no liqdty.
4th 5.29 10.85 0.68 3.62 no liqdty. no liqdty.
5th 7.05 10.85 0.96 4.52 no liqdty. no liqdty.
6th 8.81 10.85 1.20 4.52 no liqdty. no liqdty.
7th 8.81 10.85 1.40 4.52 no liqdty. no liqdty.
8th 8.81 10.85 1.90 6.33 no liqdty. no liqdty.
9th 8.81 10.85 2.40 6.33 no liqdty. no liqdty.
10th no liqdty. no liqdty. 2.68 6.33 no liqdty. no liqdty.
11th no liqdty. no liqdty. 3.00 6.33 no liqdty. no liqdty.
12th no liqdty. no liqdty. 3.20 6.33 no liqdty. no liqdty.

Source: BM&F

Guaranteed swap contracts did not present any difficulties. Daily settlements ran smoothly since the beginning of the crisis on October 23rd, thanks to the conservative margin system adopted by BM&F. In the next section, the swap risk management procedures at BM&F are detailed.

Risk management in the swaps market
The margin deposits on a guaranteed swap contract at BM&F comprises three terms:

(1) A minimum margin. This amounts to 4% p.a. for interest rate swaps and 5% p.a. for currency (US$ x R$) swaps. These are percentages over the notional value of the contract, adjusted to its maturity.

(2) The mark-to-market. This value is an estimate of the possible loss from the difference between the rate contracted for and the present market rate for a swap of identical maturity. It is estimated and paid on a daily basis. If the mark-to-market is positive, BM&F discards it in order to maintain conservative levels of coverage.

(3) A volatility factor. 10% and 15% of notional for interest rate and currency swaps, respectively. As a consequence of this factor, even positions with expressive gains due to rate fluctuations have a margin deposit in BM&F.

In addition to these three layers of protective margins, the risk of swap contracts in Brazil was also diminished by their shorter maturity. As the table below shows, at the time of the crisis, the absolute majority of swap contracts had maturities ranging between 30 and 90 days, and only some 15% had maturities longer than six months.

Percentage of swap contracts in each maturity, by November 14th

Maturity in days Interest rate swaps Currency swaps
30 22.93%  18.07%
60 16.04% 21.29%
90 19.14% 15.53%
120 13.92% 8.03%
150 9.78% 12.07%
180 3.60% 8.61%
180 to 360 14.24% 16.08%
more than 360 0.35% 0.32%


Source: BM&F

Special procedures adopted for crisis management
In sum, the main procedures adopted by BM&F for crisis management were:

(1) The rise of margin requirements (see above).

(2) The adoption of fluctuation limits for the prices of the main futures contracts: 
(3) The change in trading time to temporarily synchronize it with the NYSE.

Finally, as already mentioned, the BM&F clearing house had to be flexible in dealing with some of the larger positions. Some special settlement arrangements were required and some margin payments were managed in a case-by-case basis.
 

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