Risk-Based Haircut

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.

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.

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 securities 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.

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.

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.

What Determines the Haircut Amount?

The primary determinants that impact the haircut amount are the default risk of the borrower and the various aspects that may lead to a drop in the value of the collateral. The riskier the borrower is, meaning the more likely they will default on the loan, the higher the haircut amount will be. Similarly, the higher the likelihood that the collateral will drop in value, the higher the haircut will be.

A lender needs to assess the ability and the value that they can recover the loan if the borrower defaults on it. If a lender feels that they can sell the collateral for its market value without any issue, the haircut will be low. On the other hand, if they foresee difficulty in selling the collateral and particularly at its face value, the higher the haircut will be.

Calculation of 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.

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 10 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.

Example of a Risk-Based Haircut

Hedge Fund ABC has a margin account with Broker XYZ and will purchase futures. The fund is required to post $10 million in margin into their account for their futures purchases. As margin, Hedge Fund ABC decides to post securities, which are valued at $10 million.

Broker XYZ assesses the risk of these securities and determines that they should have a risk-based haircut of 10% to take into consideration the risk that the securities will devalue. This equates to a risk-based haircut of $1 million. The value of the securities is therefore $9 million as margin into the fund's account, meaning they will have to still post an additional $1 million to meet the $10-million requirement.