DEFINITION of 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 buying or continuing to own an 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 against a margin call.
The 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.
BREAKING DOWN Risk-Based Haircut
A risk-based haircut is a critical step in protecting against the possibility of a margin call or similar type of over-leveraged position. 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 stock options that are considered risky, the haircut can climb as high as 30%, meaning a $1,000 stock option grants a $700 loan. 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 Options Clearing House
The Options Clearing House (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 Options Clearing House. Projected prices are calculated by the closing price of the underlying asset each day plus or minus price moves from ten 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. Combining open positions and theoretical values arrive at the same appropriate capital charge.