One of the problems encountered by participants in the financial futures markets is determining the quantity of cash they will need to cover “marking-to market,” or “daily resettlement,” requirements. The authors provide a model that allows the prospective hedger (or speculator) to calculate the amount of liquidity needed and the probability of exhausting this liquidity within a given time period.
In general, the size of the liquidity pool, in the case of a single hedge, will depend on four factors—the length of time the position is to be held, the number of contracts traded, the volatility of the futures contract being traded, and the investor’s acceptable “probability of ruin”—that is, of exhausting the liquidity pool. The calculations require only one value to be estimated from the data—the daily standard deviation of the futures price changes, in dollars.
For a given liquidity pool, the probability of ruin increases with the length of the hedging horizon. Probability of ruin also varies significantly with the maturity of the contract being traded; for a given hedging horizon and liquidity pool, the probability of ruin is substantially higher with the nearby contract than with the distant contract.
