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?

REFERENCES

Allen, F., and D. Gale. 1994. “Limited Market Participation and Volatility of Asset Prices.” American Economic Review 84, no. 4 (September): 933-55.

_____. 2005. “From Cash-in-the-Market Pricing to Financial Fragility.” Journal of the European Economic Association 3, no. 2-3 (April-May): 535-46. Papers and Proceedings of the 19th Annual Congress of the European Economic Association.

Brunnermeier, M. K., and L. H. Pedersen. 2006. “Market Liquidity and Funding Liquidity.” Unpublished paper, Princeton University, November.

Holmstrom, B., and J. Tirole. 1998. “Private and Public Supply of Liquidity.” Journal of Political Economy 106, no. 1 (February): 1-40.

Pavlova, A., and R. Rigobon. 2006. “The Role of Portfolio Constraints in the International Propagation of Shocks.” Unpublished paper, MIT Sloan, December.

Shin, H. S. 2006. “Risk and Liquidity in a System Context.” Bank for International Settlements Working Paper no. 212, August.



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