FRM Exam Part II · Liquidity and Leverage

Margin, Haircuts and Collateral Funding for FRM Part II

Updated 11 October 2026 · Fact-checked

A haircut is the gap between collateral value and the cash lent against it. Margin is collateral posted to cover price moves. Both cap leverage: leverage ≈ 1 ÷ haircut. When haircuts or margins rise, borrowers must post more equity or sell assets, which forces deleveraging. Solve questions by computing funding, equity and the new leverage.

Understand Margin, Haircuts and Collateral Funding

Secured funding means you borrow cash and pledge assets. The lender does not lend the full value of the asset. It lends less, to protect itself if the asset price falls before it can sell. The cut is the haircut. In a repo, a dealer sells a security and agrees to buy it back later at a higher price. The price difference is the repo rate. The haircut sets how much of the asset the dealer must fund with its own equity.

Margin works the same way in derivatives and prime brokerage. Initial margin is posted at the start of a trade as a buffer against future price moves over a margin period of risk. Variation margin is exchanged as the position is marked to market, typically daily. It moves cash from the loser to the winner and resets current exposure to near zero. Initial margin covers what may happen after a default; variation margin covers what has already happened.

Haircuts and margins limit leverage. If the haircut is 5%, you can fund 95% of the asset with debt, so assets are 20 times equity. If the haircut is 10%, the maximum is 10 times. Leverage capacity is about 1 ÷ haircut.

The danger is that haircuts and margins are not fixed. Lenders raise them when volatility, credit risk or illiquidity rises. This is procyclicality. In calm markets, low haircuts allow high leverage and push prices up. In stress, higher haircuts shrink the debt a firm can carry against the same assets. The firm must add equity, which it often lacks, or sell assets.

These sales are fire sales. Prices fall, which cuts collateral values and triggers more margin calls and more sales. This is the loss spiral and margin spiral described by Brunnermeier and Pedersen, linking market liquidity to funding liquidity. Because many firms hold similar assets and face the same lenders, the effect spreads. Tools to dampen it include through-the-cycle margins and minimum haircut floors for non-centrally cleared securities financing.

Key formulas to remember

Haircut: Haircut = (Collateral value − Cash lent) ÷ Collateral value; Cash lent = Collateral value × (1 − haircut). Check whether the question quotes the haircut on collateral value.
Equity funded by haircut: Equity required = Asset value × haircut; The rest of the position is financed by the lender.
Maximum leverage: Assets ÷ Equity = 1 ÷ haircut; A 4% haircut allows 25 times; 10% allows 10 times.
Margin call on haircut rise: Extra equity = Asset value × (new haircut − old haircut); Assumes asset value is unchanged. If prices also fall, recompute with the new value.
Forced sale to restore leverage: Sale = Current assets − Equity ÷ haircut; Equity is after any losses. Sale proceeds repay debt.
Variation margin: VM = Mark-to-market change of the position; Paid by the party whose position lost value, usually daily.

How to solve Margin, Haircuts and Collateral Funding questions

Use this order for any numeric or conceptual question on margins, haircuts and funding.

1Identify the instrument: repo, derivative or prime brokerage. Decide whether the item is a haircut, initial margin or variation margin.
2Write down asset value, haircut or margin rate, and current equity.
3Compute debt as asset value × (1 − haircut) and equity as asset value × haircut.
4Apply any price change first. It reduces assets and therefore equity, since debt is unchanged.
5Apply any haircut or margin change to the new asset value to find the required equity.
6Compare required equity with available equity. The shortfall is the margin call, or the sale needed if the firm cannot pay.
7For forced sales, use sale = assets − equity ÷ haircut, and note the effect of falling prices on others.
8State the interpretation: procyclicality, fire sale, or liquidity spiral, and name the channel.

Quickest way: Leverage-multiple shortcut

When to use it: When the question gives a haircut change and asks for the effect on leverage, debt capacity or required equity.

Turn each haircut into a multiple: 1 ÷ haircut.
Multiply equity by the multiple to get supported assets.
The difference between old and new supported assets is the forced sale, if equity is unchanged.
Eliminate options that confuse initial margin with variation margin or ignore price losses on equity.

Common mistakes in Margin, Haircuts and Collateral Funding

Treating the haircut as the interest rate or the lender's fee.
Both reduce the borrower's economics and appear in the same repo terms.
Fix: The haircut is the collateral cushion. The repo rate is the price of the cash.
Swapping initial and variation margin.
Both are collateral and both are called margin.
Fix: Initial margin is a buffer for future moves and default close-out. Variation margin settles current mark-to-market gains and losses.
Using leverage = 1 ÷ (1 − haircut).
Mixing up the debt share and the equity share.
Fix: Equity share equals the haircut, so leverage equals 1 ÷ haircut.
Ignoring the price fall when computing the margin call after a haircut change.
Students apply the new haircut to the old asset value.
Fix: Update asset value first, then equity (assets minus unchanged debt), then compare with the new requirement.
Saying higher haircuts stabilise markets in a crisis.
Higher haircuts look prudent for each lender.
Fix: Raised in stress, they are procyclical and trigger fire sales. Stability comes from through-the-cycle or floor-based haircuts.

Worked examples

Example 1

A hedge fund holds $200 million of bonds financed in repo at a 5% haircut. The lender raises the haircut to 8% and bond prices are unchanged. The fund has no spare cash. How much must it sell to meet the new haircut, assuming sale proceeds repay debt?

Show the solution

Initial debt = 200 × 0.95 = $190 million. Equity = $10 million.
Equity stays $10 million as prices are unchanged.
Supported assets at 8% = 10 ÷ 0.08 = $125 million.
Required sale = 200 − 125 = $75 million.
Check: debt falls to 190 − 75 = $115 million; 115 ÷ 125 = 92%, so haircut 8%.

Answer: $75 million must be sold, 37.5% of the portfolio.

Example 2

A fund holds €100 million of collateral at a 10% haircut, so debt is €90 million. Prices fall 4% and the lender keeps the haircut at 10%. What margin call arises?

Show the solution

New asset value = 100 × 0.96 = €96 million.
Debt is unchanged at €90 million, so equity = 96 − 90 = €6 million.
Required equity = 96 × 0.10 = €9.6 million.
Margin call = 9.6 − 6 = €3.6 million.

Answer: The fund must post €3.6 million. A 4% price drop caused a 40% fall in equity, from €10 million to €6 million, which shows the leverage effect.

Exam tips

Always compute equity as assets minus unchanged debt after a price move. Most numeric traps are here.
Know the words: procyclicality, loss spiral, margin spiral, fire sale. Match the mechanism to the wording of the stem.
Distinguish funding liquidity (ability to roll funding) from market liquidity (ability to sell). Margin spirals link the two.
In case questions, ask who raises haircuts and why: usually higher volatility or lower collateral quality.
Check whether the stem gives the haircut on collateral or the loan-to-value ratio. They are complements.

Practice questions from Liquidity and Leverage

Margin, Haircuts and Collateral Funding: frequently asked questions

What is the difference between initial margin and variation margin?

Initial margin is collateral posted at the start to cover potential future losses during close-out after a default. Variation margin is exchanged regularly, usually daily, to cover current mark-to-market changes. The first is a buffer; the second is settlement of realised value changes.

Why is repo haircut procyclicality a problem?

Lenders raise haircuts when volatility and credit risk rise, which is exactly when borrowers are weakest. Borrowers must add equity or sell assets. Sales depress prices and trigger more calls, which amplifies the downturn.

How do margin calls cause fire sales?

A margin call demands cash or eligible collateral quickly. If a firm has no spare liquidity it sells assets, often at depressed prices. Lower prices then reduce the value of remaining collateral and can set off further calls.

How does a haircut limit leverage?

The haircut is the share of the asset you must fund with equity. Maximum leverage is 1 divided by the haircut. A 5% haircut permits 20 times equity in assets, while a 20% haircut permits only 5 times.