Haircutting Non-cash Collateral

Abstract: Haircutting non-cash collateral has become a key element of the post-crisis reform of the shadow banking system and OTC derivatives markets. This article develops a parametric haircut model by expanding haircut definitions beyond the traditional value-at-risk measure and employing a double-exponential jump-diffusion model for collateral market risk. Haircuts are solved to target credit risk measurements, including probability of default, expected loss or unexpected loss criteria. Comparing to data-driven approach typically run on proxy data series, the model enables sensitivity analysis and stress test, captures market liquidity risk, allows idiosyncratic risk adjustments, and incorporates relevant market information. Computational results for main equities, securitization, and corporate bonds show potential for uses in collateral agreements, e.g. CSAs, and for regulatory capital calculations.