Abstract
M.Com. (Financial Economics)
Since the 2008/09 financial crisis, hedge funds have been criticised for their excessive risk taking and lack of transparency involved in their trading strategies, facilitated by OTC derivatives. Basel III guidelines saw countries adopting stricter regulations to control for these risks, which led to increased costs of leverage – or initial margin – associated with the use of OTC derivatives. In addition, these regulations prohibit the ownership of physical commodities for South African hedge funds in particular. These regulations make it difficult for a South African hedge fund to participate in the JSE’s silo auction market for profit making opportunities. This study demonstrates a practical application of how a product offering from the JSE, called the ‘can-do’ future, allows hedge funds to participate in this market, thereby allowing them to trade basis. The study finds that initial margin is a key feature in profit making. Comparing the initial margin set by the JSE, and calculating using Basel guidelines, it appears cheaper to obtain leverage using an exchange cleared future such as the can-do, compared to a similar type of OTC derivative. As banks are not bound to follow Basel guidelines, the study goes further, to explore how initial margin calculated using 1-day VaR estimated by Historical simulation, Parametric and Monte-Carlo simulation methods compare. It is revealed that, should a bank opt to use these alternate methods of quantifying initial margin, the Historical method produces the cheapest and most accurate initial margin.