What Is a Risk-Based Haircut?
A risk-based haircut reduces the recognized value of an asset to determine an acceptable level of margin or financial leverage when an investor buys or continues to own the asset. In other words, haircuts attempt to measure the chance of an asset falling below its current market value and establish a sufficient buffer to protect the investor against a margin call. A margin call could force the investor to deposit more money into their brokerage account or sell assets held in the account.
For example, when an investor uses securities as collateral on a loan, the lender will usually devalue the securities by a certain amount to provide a cushion in case the market value of the security falls. This amount may be greater if the securities the investor seeks to use as collateral are considered risky by the lender. That percentage of value reduction is called a risk-based haircut.
The risk-based haircut methodology combines aspects of options pricing theory and portfolio theory to compute capital charges. This framework adheres to regulations set forth by the Securities and Exchange Commission (SEC) net capital rule under the Securities Exchange Act of 1934.
- In finance, a risk-based haircut refers to the reduction of the recognized value of an asset below its current market value.
- When an investor uses securities as collateral on a loan, the lender will often devalue the securities by a certain percentage (known as the risk-based haircut).
- This provides the lender with a cushion in case the market value of the securities falls.
- Risk-based haircuts also help protect investors from a poorly timed margin call that could force the sale of the security at a lower price.
- Risk-based haircuts can apply to various securities, including stock positions, futures, and options on futures.
Understanding a Risk-Based Haircut
A risk-based haircut is a critical step in protecting against the possibility of a margin call or a similar type of over-leveraged position. A margin call is when the value of an investor's margin account falls below the broker's required amount, requiring the investor to either deposit more money or securities into the account to bring the amount back up to the broker's required minimum value or maintenance margin.
Artificially reducing the recognized value of an asset prior to taking a leveraged position allows the actual market value of the asset to fall further than a comparable asset without a haircut before a margin call occurs. This decreases the chance of a poorly timed margin call or the forced sale of a security at a lower price. The amount of the haircut reflects the perceived risk of loss from the asset falling in value or being sold in a fire sale. In the event collateral is sold to cover the margin call, the lender will have a chance of breaking even.
The haircut is typically expressed as a percentage of the collateral's market value. For example, a risky stock worth $50 a share may receive a 25% haircut and may be valued at $37.50 if it is used as collateral. Haircuts may consist of positions in stocks, futures, and options on futures of the same underlying asset or highly correlated instruments. They also apply to different asset classes like equity, index, and currency products.
Calculating a Risk-Based Haircut
The Options Clearing Corporation (OCC) provides both the profit and loss values used to produce the portfolio margin requirement. Calculating this follows a proprietary derivation of the Cox-Ross-Rubinstein binomial option pricing model developed by the OCC. This pricing model calculates the projected liquidating prices for American style options.
The Options Clearing Corporation (OCC) provides investors with the options disclosure document (ODD), an important booklet for options traders that includes useful information on margin requirements and examples illustrating various trading scenarios.
Projected prices are calculated by the closing price of the underlying asset each day plus or minus price moves from 10 equidistant data points from an extended period. The largest projected loss for the entire class or group of eligible products (of the ten potential market scenarios) is the required capital charge for the portfolio.
For European-style options, the OCC uses a Black Scholes model. This model calculates projected prices based on the daily closing underlying asset price combined with plus and minus moves at 10 equidistant data points covering a range of market movement.