position, reducing the positive feedback effects analyzed above. At the same time, however, portfolio margining reduces the amount of overall margin, resulting in a smaller cushion if correlated shocks occur simultaneously across the whole range of margined investments.

A critical risk management issue here is the treatment of correlation assumptions in determining margin amounts for a portfolio of diverse assets. Correlations among asset prices can change radically in a crisis. A conference participant observed that a truly sophisticated risk manager would set portfolio margin requirements that take into account how those correlations can change in a crisis, and not look myopically at the average correlations of the last three years. Whether such an approach would be rewarded, however, brings us back to the earlier discussion of incentives and contrarian behavior: Do risk managers have meaningful incentives to use conservative portfolio margin requirements when their competitors are basing their margins on optimistic assumptions about correlations of margined positions?


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