| Abstract: | In Japan, brokerage commissions and margin requirements are currently regulated by the Ministry of Finance. However, commissions may soon be deregulated. This paper examines several economic factors which determine commissions and margins in a deregulated environment. The analysis is motivated by the observations that for Japan's securities companies, 1) brokerage commissions constitute a large component of their revenues; 2) margin transactions account for a significant proportion of their trading volume; 3) their gross income exhibits a great deal of volatility; 4) income tax is one of their two largest expenses; and 5) they face a significant tax asymmetry.While executing an unmargined long transaction for a customer is a riskless activity, executing either a margined long or a short transaction exposes the firm to some risk and possibly negative profits. While the commission charged by a brokerage firm for executing a riskless (unmargined) long transaction is simply equal to the marginal cost of producing the firm's total number of transactions, it is demonstrated that the gross commission charged for executing either a margined long or a short transaction includes two other components. The first additional component is a risk/tax premium that is determined by the brokerage firm's tax rate and degree of tax asymmetry, the security's volatility, and the customer's margin deposit. The second additional component is the premium required for the implicit put option associated with a margined long transaction, or for the implicit call option associated with a short transaction. The option falls in-the-money if the security's price changes significantly, so that it is optimal for the customer to default on his contract with the brokerage firm.The determinants of the customer's optimal margin, for both long and short transactions, are also examined. The benefit to the customer of depositing a higher margin is that his commission cost declines. For example, with short transactions a higher margin increases the exercise price of the implicit call option, causing both the risk/tax premium and the implicit option premium to decline. However, a higher margin may increase the customer's opportunity cost of capital. Consequently, the optimal margin increases with the firm's tax rate and degree of tax asymmetry, and decreases with the customer's opportunity cost of capital. An increase in the security's volatility has an ambiguous impact on the optimal margin.The authors are from York University, Canada and International University of Japan, respectively. Part of this paper was written while the first author was on leave at Kyoto University, Japan. We acknowledge helpful comments by Richard Arnott, Lawrence Harris, Hiromitsu Ishi, Eliakim Katz, Johannes Raaballe and Lim Kian Guan (the editor). |
