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Journal of Financial Economics 16 (1986) 213-233.

North-Holland

A THEORY OF PRICE LIMITS IN FUTURES MARKETS*

Michael J. BRENNAN
University of British Columbia, Vancouver, BC, Canada VciT I W5

Received January 1985, final version received November 1985

The existence of price limits in certain futures markets is explained by demonstrating that price
limits may act as a partial substitute for margin requirements in ensuring contract performance.
Their effectiveness is a decreasing function of the amount of information available to traders about
the equilibrium futures price which is unobservable in the event of a limit move, and the theory
predicts that no limits will exist in the markets for financial futures. Actual limits are broadly
consistent with the theory

His interpretation.. , plausible as it was, was totally misleading, with


the dangerous verisimilitude of a theory which will fit all, or nearly all,
the facts, and yet more entirely miss the truth, by a mere accident,
than would a frank perplexity.
Heritage, V. Sackville-West

1. Introduction

Trading in futures contracts currently takes place on ten organized ex-


changes in the United States and on other exchanges abroad. These exchanges,
owned by their members, compete in devising contracts which will appeal to
potential traders and thereby generate additional trading volume for the
members of the exchanges. The competition between exchanges is evident in
the large number of new contracts introduced and in the relatively small
proportion which is successful in attracting a sufficient volume of trading to
survive. This competition between the exchanges can be expected to ensure
that the contracts which are successful are those whose design minimizes the
total costs of trading for market participants. We refer to this as the hypothesis
of efficient contract design.
The hypothesis of efficient contract design does not preclude the coexistence
of two or more futures contracts on the same underlying commodity, for

*This paper was written while the author was visiting the Stockholm School of Economics and
UCLA. Financial support from SSHRC is gratefully acknowledged. Helpful comments were
received from participants in seminars at the Chicago Mercantile Exchange and various universi-
ties. The paper has benefited from discussions with Philip Dybvig, David Emanuel and Sheridan
Titman, and especially from the comments of Kenneth French, a referee of the Journal.
Silber (1981) reports that 154 new contracts were introduced by U.S. exchanges in the period
1960-80. Only 32% of those introduced in the period 1960-77 were still trading in 1980.

0304-405X/86/$3.50~1986, Elsevier Science Publishers B.V. (North-Holland)


214 M.J. Brennan, Price limits in futures markets

different traders may have different cost functions and therefore find different
contracts appropriate to them. However, it does preclude the continuing
existence of inefficient contracts which can be dominated by another contract
imposing lower costs on all market participants.2
Futures contracts are superficially similar to forward contracts in calling for
the delivery of a specified good or security3 at a specified future time. They
differ, however, in at least one, and typically in two, significant respects. First,
as Black (1976) and others have recognized, the chief distinguishing feature of
a futures market is a daily settlement rule which specifies that the gains and
losses of the two parties to a contract are realized in full each day; under a
forward contract on the other hand gains and losses are not realized until the
contract matures. A second feature of most, though not all, futures markets,
and one which is not found at all in forward markets, is a daily price limit rule:
it is this rule which is the subject of enquiry here.
In a forward-market the liability of one of the parties to a contract (and the
gain of the other party) will, at maturity, be equal to the change in the forward
price over the whole life of the contract. Therefore participants in forward
markets must either possess a strong credit reputation or post a security
deposit or margin which is sufficient to cover the likely range of price
outcomes, if significant contract enforcement problems are to be avoided. In
contrast, the liability of either party to a contract in a futures market where
daily settlement prevails is limited to the one-day change in the futures price.
Now the dispersion of one-day price changes will be much less than the
dispersion of the price change over the whole contract life with even a modest
degree of independence in successive daily price changes4 so that a daily
settlement rule greatly reduces the dispersion of the liability under a contract,
and makes it possible to attain a given level of credit risk with a much lower
level of margin than would be possible in the corresponding forward market.
On the other hand, it must be recognized that implementation of a daily
settlement rule is costly, since it causes a substantial increase in the number of
transactions: where a forward market requires only an opening and a closing
transaction for each contract, a futures market requires a transaction on each
day that a price change occurs. Thus futures markets can reduce the cost of
market participation only for individuals whose reputation is inadequate for
them to transact in a forward market without a margin deposit, and for whom
the posting of margin is costly. Margin costs may exist because individuals face
higher borrowing than lending rates due to monitoring cost and moral hazard

*Cf. Silber (1981, p. 145): The successful innovation of a futures market to supplement or
replace forward contracting stems from the reduced cost of transacting on futures exchanges.
3 Some new futures contracts call for cash settlement.
41n fact a high degree of independence can be expected in speculative markets. Cf. Samuelson
(1965).
M.J. Brennon, Price limits in fulures markets 215

considerations; they may also arise from the adverse tax treatment of the
riskless securities in which margin deposits must be invested. In any case, it
must be that the posting of margin is costly for at least some market
participants if the survival of daily settlement is to be explained.5 As we shall
see, the cost of margin may also account for the existence of daily price limit
rules, to whose consideration we now turn.
In a market with a daily price limit rule, trading is permitted only at prices
within limits determined by the settlement price of the previous day. If the
equilibrium price moves outside the limits, trading ceases until, either it moves
back within the limits, or until the next day when new limits will be set based
on the settlement price of the current day: the settlement price is an average of
the transactions prices in the closing moments of trading or, if trading is halted
at the close, it is the relevant price limit. It is apparent that a large move in the
underlying equilibrium price may cause the price to move the limit on several
successive days with no trading taking place, and this does in fact occur:
exchange rules typically provide that the limits be increased and eventually
removed as the limits are reached on successive days, and in most cases all
limits are removed as the contract approaches maturity.
Price limits impose clear costs on market participants by prohibiting mutu-
ally beneficial trades at prices outside the limits, and futures markets appear to
be the only markets in which such limits exist.6 Their existence can be
reconciled with the hypothesis of efficient contract design only if some benefit
of the limits can be identified. Several informal suggestions have been made,
but none seems to bear up under scrutiny.7
It has been suggested for example that price limits exist to prevent large
movements in prices due to panic and speculation. That they do prevent
sharp movements is undeniable since no prices outside the limits are permitted.

If there is a sufficiently large group of individuals with adequate credit reputations or for whom
the posting of margin is costless, then we may expect to observe a forward market; this may even
co-exist with a futures market if there is also a sufficiently large group for whom margin is costly.
This appears to be the situation in the market for forward delivery of foreign exchange. In other
circumstances the futures market, by widening the range of potential market participants, may be
able to provide sufficient additional liquidity to attract even those for whom margin is costless
away from a forward market.
6Telser (1981) argues that informal limits also exist in stock markets because the officers of the
exchange have discretionary power to stop trading when they believe it is necessary and desirable;
however, halts to trading in the stock market are not necessarily related to the size of the price
movement and do not restrict the magnitude of the price change over the trading day. Hopewell
and Schwartz (1978) found that 92% of the halts on the NYSE lasted less than a day and that the
mean length of these halts was 109 minutes.
As Edwards (1984) remarks: The benefits and costs associated with daily price limits on futures
prices are considerably more indefinite than their proponents and critics would have us believe.
Cf. Hieronymus (1971, p. 38): The purpose of daily limits is to prevent a major price change
from carrying too far from its own momentum. Anderson (1984): First, most futures markets
impose daily price limits to prevent excessive price swings.
216 M.J. Brennan, Price limits in futures markets

What is unexplained however is, first, why a market which is subject to panic
and speculation is inherently less desirable than no market at all; and secondly,
why futures markets should be especially susceptible to these failings; or, if all
speculative markets are equally susce@ible to them, then why price limits
should be a particularly efficacious remedy for some futures markets but not
for others, and not for other speculative markets. Furthermore, this rationale
for price limits explains neither why the maximum allowed price change is
measured from the close of the previous day, nor why it is necessary to wait
until the following day before revising the limits.
A second suggestion is that the daily price limit rule is related to the practice
of daily settlement, and that the limit on daily price changes serves to limit the
daily liability of market participants and their consequent costs of portfolio
adjustment. However, like the previous proposed explanation, this one does
not account for the existence of price limits in some futures markets but not in
others, though it does explain why price limits might exist only in futures
markets. Moreover, this explanation ignores the fact that it is possible to limit
the daily liability of market participants without imposing the costs associated
with prohibitions on trading; for example, by limiting the daily settlement
required but not limiting the daily price changes. Thus neither the possibility
of panic and speculation nor the existence of portfolio adjustment costs can
serve as the basis of a satisfactory theory of price limits in futures markets.
In this paper we develop a theory of price limits which is consistent with the
hypothesis of efficient contract design, and explains both why the limit is set on
a daily basis and why it is based on the price change since the close of the
previous day. The theory rests on the premise that margin requirements are
costly for at least some market participants, a premise which, we have argued,
is necessary to account for the existence of futures markets at all. It is shown
that price limits may serve as a partial substitute for margin requirements in
ensuring contract performance without resort to costly litigation, and that it
may be optimal to run some risk of a trading interruption by the imposition of
price limits in order to reduce the margin requirement.
A problem of contract enforcement is liable to arise in a futures market
whenever the absolute value of the change in the futures price from the
previous settlement exceeds the margin requirement, for then one party to the

9Cf. Edwards (1984).


Telser (1981) offers a third rationale for limits: that they give brokers time to consult with
their clients at times of market turbulence; this might account for trading halts but does not
explain why limits should remain in effect the whole day and why new limits should be imposed
for the day following a limit move.
This contrasts with the view of Telser (1981, p. 239) that daily limits in organized futures
markets do not affect the size of the margin.
M.J. Brennan, Price limits in futures markets 217

contract may have an incentive to renege, which would make it costly or even
impossible to enforce the contract. * A daily price limit rule can alleviate or
even eliminate this problem, since it potentially limits the information avail-
able to the losing party about the extent of his losses at the time he is required
to make the daily settlement. Knowing that the adverse price move exceeds the
limit, but not by how much, he is forced to form a conjecture about the size of
the loss. Assuming risk neutrality, his decision whether to renege will be based
on the expected loss conditional on the price limit being encountered. This
conditional expected loss is less than the maximum loss that could have been
revealed in the absence of a price limit, and therefore there will exist situations
in which, for a given margin, reneging will occur in the absence of price limits
but will be avoided if limits exist. Indeed, as we shall see below, if traders can
observe only the reported futures price, it is simple to set the price limit so that
the conditional expected loss is less than the margin: with such a limit reneging
will never occur, and the problem of contract enforcement is solved.
The situation is more complicated when the trader has access to additional
information about the equilibrium futures price, and hence about the true
magnitude of the loss. Nevertheless, the fundamental principle remains the
same. If the price limit is less than the margin, the trader cannot be sure
whether or not his loss exceeds the margin: this makes it possible to set price
limits which, while not eliminating entirely the problem of contract en-
forcement, will reduce it considerably. However, the effectiveness of price
limits is impaired by the introduction of additional information, and in the
extreme when there is a noiseless signal about the equilibrium futures price,
perhaps because of the possibility of costless arbitrage between spot and
futures markets, price limits can play no role in ensuring contract performance
and must be expected to disappear. Whether or not price limits will be part of
an efficient contract design when the signal is noisy will depend upon the signal
noise and the relative costs of margin, trading interruptions and reneging.
In the remainder of the paper the foregoing ideas are formalized in the
context of a simple three-date model of a futures market. In section 3 the
model is developed under the simplifying assumption that price changes follow
a uniform distribution and the optimal price limits and margin requirement are
derived for particular assumptions about contract costs. Section 4 presents
numerical results for the case in which the price change is normally distributed,
and the final section discusses the empirical evidence on margins and limits for
different contracts.

I2 For example, on February 28, 1984 a Malaysian palm oil refiner sold futures through a broker
on the Kuala Lumpur commodities exchange. The following day the broker announced that there
had been a mistake: its client had never asked it to sell the contracts. No margin had been
deposited. Economist, March 10, 1984,
218 M.J. Brennan, Price limits in futures markets

2. A general model of price limits and margins

A contract may be regarded as self-enforcing insofar as it is in the interest of


all parties to adhere to its terms without the threat of legal action. Since legal
action is costly and its outcome uncertain, self-enforcement is a desirable
attribute of contracts, although one that may be costly to attain.
Futures contracts are in general only partially self-enforcing, for whenever a
trader knows that the futures price has moved against him by more than the
amount of his margin deposit he finds adherence to the contract burdensome.
Despite this, he may yet find it to his advantage to fulfill the contract because
of the adverse consequences of default for his reputation and ability to
contract in the future, and the contract will still be self-enforcing. However, the
cost of possible loss of reputation will differ among traders, and the wider the
spectrum of traders attracted to a futures market the less can reputation effects
be relied on to make contracts self-enforcing.
To capture the essence of the contract enforcement problem in a futures
market we consider a two-period, three-date world and suppose that a repre-
sentative risk-neutral trader has an initial margin deposit, m, with his broker.
At time 0 the trader enters into a futures contract at the prevailing futures
price, PO. At time 1 a new price, P,, is revealed, and immediately following
this the trader receives the contract to sign: this gives him unlimited liability
under the futures contract which matures at time 2. If the trader declines to
sign, the broker is assumed to retain the margin deposit but not to recover any
further losses without costly legal action whose outcome is uncertain.
The trader will have an incentive to renege on his oral agreement if the
expected benefits exceed the expected costs. Thus let r be the probability that
reneging results in a successful default, and r be the sum of the expected
reputation and legal costs the trader must bear as a result of reneging. Then a
trader in a short position will have an incentive to renege if m[P, - P,, - m] > r,
and, noting that each contract involves both a long and a short position, there
will be an incentive for one of the parties to renege whenever the absolute price
change exceeds the effective margin, M = m + r-r,

If, - P,,( > M.

Now suppose that a maximum limit, t. is imposed on the absolute price


change, so that no trades may occur at time 1 at prices above PO+ L, or below
PO- L. Consider the decision of the losing party to the contract when the price
limit is reached at time 1 and he receives no additional information. He cannot
trade at time 1, so his attention must shift to his expected position at time 2.
Ignoring discounting, he will have an incentive to renege if his expected losses

?T reflects the probability that the creditor will not take legal action, and that if he does, it will
be unsuccessful.
M.J. Brennan, Price limits in fuiures markets 219

at time 2, conditional on the limit move,having occurred at time 1, exceed the


effective margin. Therefore a necessary and sufficient condition for neither
party ever to have an incentive to renege, so that the contract is completely
self-enforcing, is that

IE[~2-foI~l-Po>L] 1 IM, (4
where ?, is the equilibrium price that would have been observed in the absence
of the price limit. In order to evaluate the expression simply we adopt the
martingale assumption that E[ & I p,_ 1] = p,_ 1. Then, assuming a symmetric
distribution for the price change, a necessary and sufficient condition for the
contract to be completely self-enforcing is that the margin be set so that

M2E[Q(>L], (3)

where 2 = P, - PO. Since margin is costly it will never be optimal to set M and
L so that (3) holds as a strict inequality; therefore the equality in (3) defines
the optimal self-enforcing contract margin level14 as a function of the price
limit M(L). Note that M(L) 2 0, so that a price limit rule can reduce the
level of margin required for a contract to be completely self-enforcing: this of
course requires that L < M. On the other hand, if L < M but (3) is violated,
reneging will occur whenever there is a limit move, and the incidence of
reneging will not only be decreasing in L but will actually be higher than it
would have been in the absence of a price limit rule, since reneging will occur
whenever ( x I > L, instead of only when ( 2 ( > M. Thus a well-chosen price
limit rule can make a contract completely self-forcing;15 on the other hand, an
ill-chosen one can exacerbate the problem of enforcement.
To this point it has been assumed that the trader has no external source of
information about the equilibrium futures price, pt, so that in the event of a
limit move he is obliged to form a conjecture about the equilibrium price based
only on the marginal distribution of price changes. Now, suppose to the
contrary that the trader is able to observe a signal ?, which is correlated with
the change in the equilibrium price, 2. Such a signal may be derivable from
the spot market for the underlying commodity or asset, from the markets for
other futures contracts, or from other sources.
As before, reneging will occur by one of the parties to the contract whenever
the expectation of I 2 ( conditional on the available information exceeds the

l4Henceforth we shall assume that all traders have identical values of r, and we shall ignore the
distinction between the margin and the effective margin; the only effect of this is to change the cost
of the market by a constant. See footnote 17.
I5 This of course presumes that the conditional mean in (3) is defined.
220 M.J. Brennan, Price limits in futures markets

margin, M. This implies that a price limit rule will have no effect on the
incidence of reneging if L 2 M, for then it would always be possible to observe
directly whether ) _f ( 2 hf. We therefore restrict our attention to effective price
limit rules such that L -c M.
Under an effective price limit rule reneging will occur for a positive price
change16 if and only if

hL, (4
and

Assume that LHS of (5) is increasing in Y and that there exists a critical
value Y *( L, M) defined by equality in (5); then it is optimal for a trader in a
short position to renege whenever Y > Y *(L, M) and 22 L. Taking account
of the symmetry of short and long positions the probability that reneging will
occur is given by

2Pr(Z2L, F2 Y*(L, iv)). (6)


It follows from the monotonicity of the conditional expectation in (5) that
the critical signal level Y * is decreasing in the limit, L, so that the probability
of reneging, conditional on a limit move, increases with L. On the other hand,
the probability of a limit move decreases with L, and therefore an increase in
L may either increase or decrease the incidence of reneging depending on the
joint distribution of the signal and price change and the precise combination of
limit and margin. Indeed, as the no external information case exemplifies, it is
even possible that the imposition of an ill-chosen limit rule may increase the
incidence of reneging beyond what it would have been without a price limit
rule.
In order to reach stronger conclusions about the optimal combination of
margins and limits it is necessary to make assumptions both about the
probability distribution of price changes and about the costs of margins, limits
and reneging. We shall consider first the costs.
We assume that an efficient contract is designed to minimize the total cost of
participation in the market for a representative trader who takes a position in a
single contract. We take as given the daily settlement arrangement and concern
ourselves solely with the costs of margin and of limits and the costs of contract
enforcement.

I6 We shall assume that the joint distribution of (X, Y) is symmetric about the origin so that the
analysis for a negative price change is similar.
M.J. Brennan, Price limits in futures markets 221

First, the cost of the margin requirement is assumed to be, in the nature of
an opportunity cost of funds, KM, where K > 0.17 Secondly, the cost of price
limits arises from the loss of liquidity due to the possibility of trading
interruptions. At one extreme, if the limit is set so high that the probability of
a trading interruption is zero, the cost of the limit is zero. At the other extreme,
as the probability of the limit being reached during the day approaches unity,
the market will cease to operate, and it is convenient to take the cost as infinite.
Motivated by these considerations, we shall assume that the cost of price limits
is proportional to the ratio of the probability that the limit is reached and no
trading takes place, to the probability that the limit is not reached. Then the
cost of the limit may be written as

(7)

The final component of cost to be considered is the cost of reneging. This


cost will include not only the deadweight legal and reputation costs borne
directly by the trader, but also the legal and other costs borne by the broker in
attempting to enforce the contract which will be passed on to traders in the
form of higher commissions. Lacking any formal theory of the determinants of
these costs, we shall assume simply that a fixed cost (Yis incurred whenever the
trader reneges.
Then the total cost of participation in the market for a representative trader,
C(A4, L), is given by

Pr( lXl2L)
C(hf,L)=KM+y
Pr( 121 CL)

+2aPr(X2 L, F2 Y*(M, L)), (8)

and the terms of an efficient contract, M and L, will be set to minimize this
cost.
In the following section we consider the terms of an efficient contract, first in
the simple case in which the price change follows a uniform distribution and
the trader receives no external information about the equilibrium price, and
secondly when he receives a signal which is equal to the equilibrium price plus
a uniformly distributed error term.

Cf. Telser (1981, p. 235): The margin he must deposit imposes a cost that is proportional to
its size. Note that the only effect of introducing legal and reputation costs of reneging for the
trader is to reduce the margin costs from KM by the constant Krmlr.
222 M.J. Brennan, Price limits in futures markets

3. Uniformly distributed price changes

3.1. No external information

If price changes are uniformly distributed and the trader receives no external
information about the equilibrium price, then it is always possible to find a
combination of margin and limits which will make the contract completely
self-enforcing: we shall assume that the costs of contract enforcement are such
that the optimal contract is completely self-enforcing.18 Consistent with the
martingale assumption, the price change each day is taken as uniformly
distributed in the interval [-b, b]. Then, recognizing that only the first two
terms of (8) are relevant for a completely self-enforcing contract, the cost of a
contract with margin M and limit L is given by

C(M,L)=KM+y(b/L-1), L<b,
(9)
= KM, LT b.

Moreover, it follows from condition (3) and the properties of the uniform
distribution that the minimum, and therefore the optimal, margin for a
completely self-enforcing contract with limit L is

M(L)=(b+L)/2, Lsb,
(10)
= b, L> b.

Then we may substitute from (10) in (9) to express the total cost of the
contract as a function only of the limit, L,

C(M(L),L)=y(b/L_l)+K(b+L)/2, Lsb,
(11)
= Kb, Lkb.

The first-order condition for a minimum in (11) is19

- yb/L= + K/2 = 0, Lcb. (12)

For L > b the limit is ineffective and has no effect either on default or on
trading: in effect there is no limit at all. Therefore from (12), the optimal limit,
L*, is given by

L*=dm, b 2Y/K,
03)
= 0, b < 2Y/K.

Unless this condition is satisfied a contract without limits is optimal since, as we have seen,
introduction of limits will increase the incidence of reneging unless (3) is satisfied.
19The second-order condition is satisfied since Zyb/L > 0.
M.J. Brennan, Price limits rn futures markets 223

M=b
no limit

/
/
/
/
/
/
I/

Fig. 1. Optimal limit (L*) and margin (M*) in a market with uniformly distributed price changes
and no external information. h = price change range, y = cost of trading interruptions, K = cost of
margin.

Substituting for L in (10) the optimal margin requirement is then

= 6, bs2y/K.

When b > 2y/~ so that the efficient contract includes a price limit rule, the
optimal margin and limit are both increasing in the trading interruption cost
parameter y and in b, the range of the absolute price change: they are both
decreasing in K, the cost of margin.
M* and L* are plotted in fig. 1 as functions of the range of the absolute
price change, b. For small values of b, or low risk markets, the optimal
contract requires no price limit and a margin sufficiently high to cover the
maximum possible price change. As b increases, the ratio b/L* falls, so that it
is optimal to accept a higher probability of trading interruptions in high-risk
markets; this is because the cost of eliminating default through margin
requirements is proportional to b for a given L.
Maintaining the assumption that a completely self-enforcing contract is
optimal, the value of price limits to market participants may be calculated as
the difference between the cost of the contract when there are no limits,
C(b, co), and the cost when the optimal margin and limit are imposed.
224 M.J. Brennan, Price limits in futures markets

Substituting from (13) and (14) in (11) the social value of limits, Q, can be
written as

Q=Kb/2-m+y, b > 2y/K. (15)

This implies that &Q/~K > 0, SQ/Sy < 0, and 6Q/Sb > 0, so that limits
have most value in high-risk markets where the cost of margin is high relative
to the cost of trading interruptions.

3.2. The e#ect of external information


Maintaining the assumption that the price change is uniformly distributed in
the interval [ -b, b], assume now that the trader also observes a signal ? given
by

Y=R+z, (16)
where Z: is independent of X and is uniformly distributed on the interval
[_-c, c]. Conditional on a (positive)_ limit move and a realization of the signal
Y, the equilibrium price change X is uniformly distributed on the interval
[max(L, ? - c), min(b, ? + c)], so that

E[X&L,?]=${ max(L,?-c)+min(b,~+c)}, (17)

and the critical signal level Y *( L, M) above which reneging occurs for a limit
move is defined by

max(L, Y* - c) + min( b, Y * + c) = 2M. (18)

Line 1 of table 1 gives explicit expressions for Y *( L, M) for different ranges


of L and M. Given the critical signal level, Y *, the probability of reneging for
a limit L, P( Y *, L), is equal to 2Pr( _%2 L, q 2 Y *). Line 2 of the table given
the corresponding expressions for P( Y *, L), and line 3 gives the expressions
for 8( L, M), the probability of reneging as a function of the margin and limit:
this is obtained by substituting the appropriate expression for Y*( L, M) in
P(Y*, L).
In order to obtain a tractable formulation for the problem of determining
the optimal limit and margin it is necessary to modify slightly our assumed
cost function, and we shall assume for the balance of this section that the cost
of the limit is proportional to the square of the probability that a limit move
M.J. Brennan, Price limits in futures markets 225

Table 1
The probability of reneging for alternative combinations of margin deposit requirement and price
move limiLa

L<b-2c

(4 W (Cl
LsMsL+c LicsMsb-c b-c<Msb

1. Y*(L, M) 2M-L-c ZM-b+c


2. p(Y*, L) (l/b)[b-L-(Y*- L+c)~,~c] (l,b)[:- Y*] (b + c - Y*)*,4bc
3. P(L,M) (l,b)[b - L - (M - L)*/c] (l/b)[b - Ml (b- M)*/bc

Lzb-2c

CD) (El
Ls M<(b+ L)/2 (b+L)/2< Msh

1. Y*(L, M) 2M-L-c 2M-b+c


2. P(Y*, L) (l/b)[b- L-(Y*-L+c)*/4c] (bit- Y*)2/4bc
3. p(L, M) (l,b)[ b - L - (M - L)2/c] (b - M)*/bc

M = Margin requirement, L = limit, Y*( M, L) = critical signal level, j( L, M) =


P( Y*( L, M), L) = probability of reneging.

occurs and trading is halted. Then the cost of a contract may be written as

and the optimal combination of margin and limit will minimize this cost. As
seen in table 1 there are five different cases to consider in evaluating ?(L., M)
and C(M, L), depending on the values of L and M. At the optimum
C( M, L), and therefore ?( L, M), must be strictly convex functions of M. This
condition is satisfied only for values of L and M in the ranges specified by
cases C and E and they yield the same expression for the probability of
reneging, (b - M)2/bc. Since the limit does not enter directly into this
expression it will be optimal to set the limit at the highest level consistent with
these cases. Hence we have either case C: (L = b - 2c, b - c 2 M I b), or case
E: (L = 2M - b). For case E the problem of efficient contract design may be
written

pir$( M, L) = KM + $y( b - L)* + a( b - M)2,bc, (20)

subject to

L=2M-b, L 2 b - 2c,
226 M.J. Brennan, Price limits in futures markets

and the solution is

M * = b [I- Kc/(tybc + 2ar)],

L* = 2M* - b.20

The condition for L 2 b - 2c is that K 5 4yc + 2a/b.


The optimal margin and limit are both decreasing in the signal noise c. In
the limit as the signal becomes more precise (c -+ 0) the optimal contract calls
for both the limit and the margin to approach the maximum price change, b, if
K s 2a/b. On the other hand, if K > 2a/b the necessary condition for an
interior optimal limit will be violated as c + 0 and the optimal contract will be
one with no price limits. Thus, as the precision of the external signal increases,
we expect the price limits to be either relaxed or abandoned.

4. Normally distributed price changes with external information


The uniform distribution, while yielding an analytically tractable formula-
tion of the problem of efficient contract design, is not particularly plausible. It
is useful therefore to supplement the foregoing analytic results with some
numerical results for the normal distribution. We will assume therefore that
_%- N(0, cr,) and that the external signal is of the form ? = X + 0, where Z is
uncorrelated with _% and Z - N(0, u,). Conditional on the signal Y, X -
N(bF, at), where b = u,/(u, + u,) and $ = (1 - b)u:. Then, using the prop-
ertie_s of truncated normal distributjons, it can be shown that E[ X ] X 2 L, Y]
= bY + u,h(lj), where 4 = (L - bY)/u,, h(q) = n(q),41 -N(q)), and n(.)
and N( .) are the standard normal density and distribution functions, respec-
tively. It follows that the critical signal level above which reneging occurs for a
positive limit move, Y *( L, M) is given implicitly by

bY*+h[(L-bY*)/o,] =M. (21)

The probability that trading will be halted due to a limit move is 2N( - L/u,),
and the probability that reneging will occur, given Y * and L, is 2 /,N[( X -
Y *)/a,] d N( X/u,). In this expression N[( X - Y *)/a,] is the probability that
Y > Y * given X 2 L. Then, reverting to our original cost function (8) the

The reader may verify that the second-order conditions are satisfied. There is no need to
consider a case C type optimum since the necessary condition for M t b - c in this case is
sufficient to guarantee an interior optimum in (20).
h4.J. Brennan, Price limits in futures markets 22-l

problem of efficient contract design may be written as

2YN-wx)
lIliIlC(l%f, J!,) = KM+
L. M 2N( L/u,) - 1

(22)

where Y* is given by (21).


This problem is amenable to comparative statics analysis only in the extreme
cases when the signal noise is either infinite or zero. The former case is
cumbersome to analyze and yields no new insights: in the latter case price
limits have no effect on the incidence of reneging and, since they are nonethe-
less costly, they are not part of an efficient contract, as we found for the
uniform distribution. A noiseless signal of the equilibrium futures price change
will be available in the spot market price change whenever there is costless
arbitrage between the futures and spot markets; since close to perfect21
arbitrage possibilities exist in the markets for interest rate, currency and stock
index futures, our theory predicts that price limit rules will not exist for these
markets. In addition, to the extent that metals are held in inventories and the
net convenience yield depends only on the spot price, the spot price for these
commodities also will serve as a perfect predictor of the futures price,22 and
price limits should not be observed. Finally, for all contracts the correlation
between spot and futures prices approaches unity as the contract approaches
maturity since the spot and futures prices are equal at maturity, so that we
should not expect to observe price limits for very short-term contracts.23
However, for agricultural commodities, where the basis risk is typically sub-
stantial, we expect to find a role for price limits, at least in the distant contract
months.
To explore the effect of signal precision on the optimal combination of
margin and limits problem (22) was solved numerically for particular parame-
ter values, and the results are summarized in table 2. In constructing this table
ax was taken as 1000 and the following values were used for the parameters of
the cost function: K = 0.02%, y = 1, (Y= 50. The value of the margin cost
parameter corresponds to an annual interest rate of about 5%. Three different

t Only close to perfect because of interest rate uncertainty [see Cox, Ingersoll and Ross (1981)],
and because of the delivery grade option for some interest rate futures, and uncertainty about
future dividends for stock index futures.
22See Brennan and Schwartz (1985).
23A further reason for having no limits close to maturity is to ensure that positions can be closed
out without the costs of making or taking delivery.
228 M.J. Brennan, Price limits in futures markets

Table 2
Cost of a futures market with external information for alternative combinations of margins deposit
requirement and price move limits.=

Probability
of reneging cost
Probability Probability without without
Margin Limit Y* of halt (%) of reneging (I%) limit (W) cost limit

p = 0.50
2400 1800 6080 1.2 10.2 x 10-z 164.2 x lo- * 0.609 1.300
2600 1900 7690 5.7 0.7 93.4 0.584 0.987
2800 2200 7690 2.8 0.5 51.2 0.591 0.816
3000 2500 7370 1.2 0.6 27.1 0.616 0.736
3200 2600 9330 0.9 0.0 13.8 0.649 0.709
3400 2900 9020 0.4 0.0 6.8 0.684 0.714
3600 3200 8170 0.1 0.1 3.2 0.722 0.736
3800 3100 12940 0.2 0.0 1.5 0.762 0.767

p = 0.75
2400 1600 3860 10.9 32.5 x 10m2 164.2 x 1O-2 0.766 1.300
2600 1900 4070 5.7 18.0 93.4 0.671 0.987
2800 2000 4580 4.6 5.1 51.2 0.633 0.816
3000 2300 4780 2.1 2.7 27.1 0.635 0.736
3200 2600 4940 0.9 1.5 13.8 0.657 0.709
3400 2700 5500 0.7 0.3 6.8 0.688 0.714
3600 3000 5670 0.3 0.1 3.2 0.723 0.736
3800 3300 5760 0.1 0.1 1.5 0.761 0.767

p = 0.96
2400 1800 2600 7.2 127.0 x 10-12 164.2 x 1O-2 1.192 1.300
2600 2100 2800 3.6 72.2 93.4 0.918 0.987
2800 2200 3030 2.8 36.2 51.2 0.169 0.816
3000 2500 3240 1.2 19.1 27.1 0.708 0.736
32Wh 2600 3470 0.9 8.8 13.8 0.693 0.709
3400 2900 3680 0.4 4.2 6.8 0.705 0.714
3600 3000 3900 0.3 1.8 3.2 0.732 0.736
3800 3300 4110 0.1 0.8 1.5 0.165 0.767

uX = 1000. The costs are computed using K = 0.02%. y = 1, (Y= 50.


Y* = critical signal level above which reneging occurs for a positive limit move.
Least cost margin/limit combination.

extra-market signals were analyzed, differing in their precision as measured by


p, the correlation between the signal and the equilibrium price change. Con-
tract costs for each of the three signals were computed for margins at intervals
of 200, and for each margin for limits at intervals of 100. Results for only the
cost-minimizing limit for each margin are shown in the table.
When p = 0.5 the efficient contract calls for a margin of 2600 and a limit of
1900: under this arrangement the probability of a trading halt is 5.7% and the
probability of reneging is only 0.007%; without a limit the probability of
M.J. Brennan, Price limits in futures markets 229

reneging for the same margin would be 0.93%. However, if there were no limit
it would be optimal to increase the margin to 3200. This would result in a total
contract cost of 0.709 compared with a cost of 0.584 under the efficient
contract.
As the signal correlation is increased to 0.75 and 0.96, the efficient
margin/limit pair rises to 2800/2000 and 3200/2600, respectively. Given the
reduced effectiveness of the limit in ensuring performance as the signal
precision increases and our results for the uniform distribution, it is not
surprising to find that the burden of ensuring performance is optimally shifted
from the price limit rule to the margin requirement as signal precision
increases. At p = 1 the whole of the burden is borne by the margin and, as
discussed above, price limits are not part of the efficient contract. The increase
in the efficient price limit as p rises causes the probability of trading halts
under the efficient contract to fall to 4.6% for p = 0.75 and to 0.9% for
p = 0.96; correspondingly, the probability of reneging rises to 0.051% and
0.088%. The reduced effectiveness of the price limit rule as signal precision
increases is evident in the increase in the total efficient contract cost from 0.633
for p = 0.75 to 0.693 for p = 0.96, in comparison with the minimum cost
attainable without price limits of 0.709. However, the potential effectiveness of
price limit rules in the presence of a moderately accurate signal is illustrated by
the finding that removal of the limit from the efficient contract when p = 0.75
would lead to an increase in the incidence of reneging of 900% for the same
level of margin.

5. Some empirical evidence on margins and lim;ts


Our model predicts that price limits will not exist in the markets for interest
rate, currency, stock index and (possibly) metal futures. Table 3 reports the
relation between limits and customer margin requirements for a major broker
in October 1984. The margin requirement is taken as the maintenance margin
for net speculative positions: this is set by the broker subject to a minimum
level which is determined by the exchange and varied from time to time in
response to changes in price volatility. Price limits on the other hand, while set
by the exchange, must be approved by the Commodity Futures Trading
Commission; as a result of the regulatory process changes in limits tend to be
more sluggish than changes in margins.
We observe first that, as our theory predicts, there were no limits for any of
the stock index futures. It is significant however that several of these contracts
commenced trading subject to price limits which were only subsequently
removed as their redundancy became apparent. The other financial futures
contracts were subject to price limits at the time the data were collected,
contrary to our predictions. However, since then the limits on all currency
futures contracts have been removed by the International Monetary Market
230 M.J. Brennan, Price limits in futures markets

Table 3
Price limit and margin requirements for major broker, October 1984

Limit/margin Increase in
prior to margin in
Contract Exchange delivery month delivery month (%)

Agricultural Commodities
Cattle, Feeder CME 0.73 67
Cattle, Live CME 0.86 71
Cattle, Live CA 0.75 125
Cocoa NYCSCE 0.59 33
Coffee NYCSCE 0.83 33
Corn CBOT 0.83 17
Corn MA 0.83 0
Cotton NYCTE 0.91 82
Hogs CME 0.64 29
Hogs CMA 0.56 75
Lumber CME 0.72 33
Oats CBOT 1.25 0
Oats MA 0.50 0
Orange Juice NYCTE 0.50 33
Plywood CBOT 0.76 29
Pork Bellies CME 0.63 25
Soybean Meal CBOT 0.71 0
Soybean Oil CBOT 0.55 0
Soybeans CBOT 0.68 0
Soybeans MA 0.46 15
Sugar NYCSCE 0.75 60
Wheat CBOT 1.43 0
Wheat KCBT 1.79 0
Wheat MPLS 1.79 0
Wheat MA 1.00 - 50
Average 0.82 30

Metals
Copper COMEX 1.79 28
Gold CBOT 2.68 0
Gold COMEX 1.67 0
Gold MA 2.66 0
Palladium NYME 0.75 50
Platinum NYME 1.04 58
Silver COMEX 1.00 0
Silver, New CBOT 0.83 0
Silver MA 0.83 - 0
Average 1.47 15

suggesting that price limits on financial futures contracts are merely a vestigial
remnant, perhaps included originally in the new contracts as a sop to con-
servatism. Of the financial futures, limits remain only for the interest rate
contracts and for these the limits are always at least as great as the margin
requirements so that they play no role in inhibiting reneging for individuals
M.J. Brennan, Price limits in futures markets 231

Table 3 (continued)
- -
Limit/margin Increase in
prior to margin in
Contract Exchange delivery month delivery month (%)
-
Currency
Br. Pound IMM 1.04 25
Can. Dollar IMM 1.07 29
DM IMM 1.04 25
DM MA 0.96 38
FF IMM 0.83 33
Yen IMM 1.04 25
Yen MA 0.96 38
Peso IMM 0.19 100
SF IMM 1.25 33
SF MA 1.17 - 62
Average 1.04b 41
-
Stock Index
Major Market CBOT no limit 0
NYSE Index NYFE no limit 0
S&P 500 IOM no limit 0
S&P loo IOM no limit 0
Value Line Index KCBT no limit 0
Value Line Mini KCBT no limit - 0
Average 0

Interest Rate
Cert. of Deposit IMM 2.00 30
Euro. $ IMM 2.50 10
GNMA CBOT 1.00 0
Treasury Bills IMM 1.50 50
Treasury Bills MA 1.25 33
Treasury Bonds CBOT 1.00 0
Treasury Bonds MA 1.00 - 0
Average 1.46 17

Since these data were compiled all limits on currency futures have been removed by the IMM.
hExcludes Peso contract.

with no reputation to lose, and to this extent they may be regarded as purely
ornamental. It may be noted also that the interest rate futures contracts
introduced more recently in London on the Chicago model are not subject to
daily price limits.24
For most of the metals contracts also, the price limits equal or exceed the
margin requirement, and for gold where the basis is almost solely a function of
interest rates, the price limits greatly exceed the margin.

24These contracts do have limits, but when the limit is reached trading ceases for only 15
minutes.
232 M.J. Brennan, Price limits in futures markets

We have argued that, if the only source of information about the equilibrium
futures price is the spot price, then price limits are likely to be most effective in
agricultural markets where there is substantial variation in the basis for most
commodities. This hypothesis is supported by the evidence that for 20 out of
25 contracts the limit is less than the margin, averaging 66% of the margin for
these contracts. The anomalous contracts are in wheat and oats and conversa-
tions with exchange officials suggest that these anomalies are due to declining
price volatility in these contracts which has led to a reduction in the margin
requirement while the limit, as mentioned above, is slow to adjust. It may well
be the case also that the substantial surpluses in these commodities which have
reduced price volatility have also reduced variation in the basis.
It has been suggested by the referee that the recent introduction of trading in
options on agricultural futures provides a test of the predictions of our theory.
Clearly, the call put price differential provides accurate information about the
equilibrium futures price, and therefore we should expect that either limits will
be placed on the option contracts also or limits will be removed from the
corresponding futures contracts. The evidence to date is mixed: the Chicago
Board of Trade has placed limits on the new option contracts,25 but the
Chicago Mercantile Exchange has not, and has retained them on the corre-
sponding futures contracts. Since the option contracts are only a few months
old it is too soon to tell whether either of these represents a stable arrange-
ment.
Table 3 also reports the increase in the margin requirements during the
delivery month when price limits are in most cases removed. We should expect
the removal of price limits in the delivery month to increase the margin
requirements for those contracts for which the price limit plays a significant
role in controlling default risk. 26 On the other hand, our theory does not
predict any increase in the margin in the delivery month for the contracts for
which price limits are either non-existent or purely ornamental. The data
provide only limited support for these predictions. It is encouraging to find no
increase in the margin in the delivery month for any of the stock index futures
contracts, compared with an average increase of 30% for the agricultural
contracts and 69% for the other non-financial contracts. On the other hand, it
is perplexing to find that all the currency contracts and half the interest rate
contracts did impose increased marginrequirements in the delivery month.

The limits on the options are identical to those on the futures. Put call parity suggests that if
the integrity of the futures limits are to be maintained, the limits on the option contracts should be
on the change in the call put price differential. This may be difficult to implement. An alternative
would be to suspend trading in the options after a limit move in the underlying futures.
26Even if the limits were not removed we might expect the greater correlation between spot and
futures prices in the delivery month to lead to an increase in the margin requirements for their
contracts.
M.J. Brennan, Price limits in futuresmarkets 233

A possible explanation for the increase in the margin for these contracts is
that the increased margin requirement in the delivery month serves not only to
reduce the risk of default, but also to reduce the open interest in the maturing
contract and the consequent probability of physical delivery. This might
explain why there is no increase in the margin for stock index futures where
there is cash delivery, while there is an increase for currency contracts and
some of the interest rate contracts. However, this is mere conjecture and falls
beyond the purview of the theory we have developed in this paper.

Postscript: After this paper was written the IMM eliminated price limits on
its interest rate contracts.

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