FRM Exam Part II · Margin (Collateral) and Settlement

Collateral Haircuts, Wrong-Way and Liquidity Risks

Updated 11 October 2026 · Fact-checked

A collateral haircut cuts the value of non-cash collateral to cover price, FX and liquidity risk over the close-out period. Collateral value = market value × (1 − haircut). Solve by finding the exposure, haircutting each asset, then checking cheapest-to-deliver choices, wrong-way correlation and liquidity needs.

Understand Collateral Haircuts, Wrong-Way and Liquidity Risks

Cash is the best collateral because its value is certain. Many agreements also accept bonds, equities or other assets. These can fall in value before you sell them. A haircut is a percentage cut applied to the market value of the asset. You get credit only for the reduced value.

A haircut covers the loss you could suffer between the last margin call and the sale of the collateral. That is the margin period of risk. It has three parts: price risk of the asset, FX risk if the collateral is in a different currency from the exposure, and liquidity risk if a forced sale moves the price. Haircuts are higher for volatile, long-dated, lower-rated and illiquid assets. Under Basel, a currency mismatch usually adds a separate FX haircut.

Many CSAs let the poster choose which eligible asset to deliver. This is the cheapest-to-deliver (CTD) option. The poster will deliver the eligible asset with the lowest opportunity cost to the poster per unit of collateral credit received. That is the asset the poster values least elsewhere. The receiver ends up holding the least valuable or riskiest eligible asset, so the option has value to the poster. Valuing collateral as if it were cash ignores this.

Wrong-way risk arises when exposure to a counterparty rises as its credit quality falls. It is worse for collateral if the posted asset is linked to the poster. Examples are a bank posting its own bonds or a firm posting shares of its parent. In stress the collateral loses value just as the counterparty defaults. Haircuts based on normal markets then understate the loss.

Collateral liquidity risk has two sides. Posting collateral drains your liquid assets and raises funding cost, especially when you must post high-quality assets. Receiving collateral gives you protection only if you can sell it at a fair price. In a crisis, haircuts rise and eligibility shrinks, which triggers more calls. This is procyclical and can force fire sales.

Key formulas to remember

Collateral value after haircut: Adjusted value = Market value × (1 − H); H is the haircut as a decimal. Use it for each asset separately.
Net exposure after collateral: Net exposure = max(0, Exposure − Σ adjusted collateral); Exposure cannot be negative for the receiver. Ignores threshold and minimum transfer amount unless given.
Gross-up for a required haircut: Market value needed = Required value ÷ (1 − H); Use when asked how much collateral to post to cover a given amount.
Combined haircut (price and FX): Adjusted value = Market value × (1 − H_price) × (1 − H_FX); Basel treats these as separate adjustments. Some questions simply add them, so follow the stated method.
Haircut from volatility: H ≈ z × σ × √T; σ is the volatility per unit time, T is the margin period of risk in the same unit, z is the normal quantile (for example 2.33 at 99%). It is an approximation that assumes normal returns.

How to solve Collateral Haircuts, Wrong-Way and Liquidity Risks questions

Work from exposure to collateral value, then test the risks the question points to.

1Write down the exposure to be covered and any threshold, independent amount or minimum transfer amount.
2List each collateral asset with market value, currency and stated haircut.
3Apply haircuts to each asset: market value × (1 − H). Add an FX haircut if currencies differ.
4Sum adjusted values and compare with exposure to find excess or shortfall.
5If the poster has a choice of assets, the cheapest-to-deliver one is the eligible asset with the lowest opportunity cost to the poster per unit of collateral credit received, which is the asset the poster values least elsewhere. The receiver is left with the least valuable or riskiest eligible asset.
6Check for wrong-way risk: is the collateral issuer the counterparty, its parent, or driven by the same factor?
7State the liquidity effect: stressed haircuts, extra calls, or loss of liquid assets for the poster.
8Give the conclusion with the right direction: who is protected, who bears the cost.

Quickest way: Haircut, subtract, then ask who is hurt

When to use it: Use for numeric MCQs with a table of collateral and a single exposure.

Multiply each market value by (1 − H) and add them up.
Subtract from exposure. A negative result means over-collateralised.
For a required amount, divide by (1 − H) instead.
If the option text mentions the poster's own paper, think wrong-way risk, but check the question wording first.
If the poster chooses the asset, the CTD is the eligible asset with the lowest opportunity cost to the poster per unit of collateral credit received, i.e. the asset the poster values least elsewhere.

Common mistakes in Collateral Haircuts, Wrong-Way and Liquidity Risks

Multiplying by H instead of (1 − H).
The word haircut sounds like the amount that remains.
Fix: The haircut is the cut. Value kept = (1 − H). A 10% haircut on 100 gives 90.
Adding the FX haircut to the price haircut when the question gives a multiplicative rule, or the reverse.
Both methods exist in practice.
Fix: Use the method the question states. If none is stated, multiply the two (1 − H) factors and say so.
Dividing instead of multiplying when asked how much collateral to post.
Confusion between the market value needed and the value credited.
Fix: Market value needed = required value ÷ (1 − H). Check that haircutting the answer returns the requirement.
Treating the CTD option as worth nothing to the receiver's risk view.
Students value collateral at market price only.
Fix: The poster can switch to the asset that is cheapest for it, so assume the receiver holds the worst eligible asset in stress.
Calling any correlation between exposure and collateral wrong-way risk.
The term is used loosely.
Fix: Wrong-way risk means exposure rises as the counterparty's credit worsens, or collateral value falls with the counterparty's credit.
Assuming a haircut removes liquidity risk.
A fixed haircut looks like full protection.
Fix: Haircuts are set for normal conditions. In stress, haircuts rise, prices gap and calls increase, so a gap risk remains.

Worked examples

Example 1

A bank has a net exposure of USD 50 million to a counterparty. The counterparty posts USD 30 million of government bonds (haircut 4%) and USD 25 million of corporate bonds (haircut 12%). Ignore thresholds. What is the remaining uncollateralised exposure?

Show the solution

Government bonds: 30 × (1 − 0.04) = 28.8.
Corporate bonds: 25 × (1 − 0.12) = 22.0.
Total adjusted collateral = 28.8 + 22.0 = 50.8.
Net exposure = max(0, 50 − 50.8) = 0.

Answer: The uncollateralised exposure is zero. The bank is over-collateralised by USD 0.8 million after haircuts.

Example 2

A bank must hold collateral worth USD 18 million after haircuts. It will accept EUR-denominated bonds with a 6% price haircut and an 8% FX haircut, combined multiplicatively. How much market value of the bonds must be posted, in USD million (to two decimals)?

Show the solution

Credit factor = (1 − 0.06) × (1 − 0.08) = 0.94 × 0.92 = 0.8648.
Market value needed = 18 ÷ 0.8648.
18 ÷ 0.8648 ≈ 20.81.
Check: 20.81 × 0.8648 ≈ 17.99, which matches 18 within rounding.

Answer: About USD 20.81 million of bonds must be posted.

Exam tips

Read whether the question asks for value credited or value to post. They need opposite operations with (1 − H).
When a bank posts its own bonds or a related issuer's securities, that is a classic example of wrong-way risk. Check the question wording before answering.
Link haircut drivers to the margin period of risk: longer period, more volatile or less liquid asset means a larger haircut.
For liquidity questions, name the procyclical effect: stress raises haircuts and calls, which forces asset sales.
Know the CTD option as a concept: the poster chooses, so the receiver should assume the worst eligible asset in stress.

Practice questions from Margin (Collateral) and Settlement

Collateral Haircuts, Wrong-Way and Liquidity Risks: frequently asked questions

How do you calculate a collateral haircut?

Multiply the market value of the asset by (1 − haircut). A 10% haircut on USD 100 million of bonds gives USD 90 million of credit. If you need a target credit amount, divide it by (1 − haircut) to find the market value to post.

What is the cheapest-to-deliver collateral option?

It is the right of the poster, under many CSAs, to choose which eligible asset to deliver. The poster picks the asset that is cheapest for it to give up. This has value to the poster and transfers risk to the receiver.

What is wrong-way risk in collateralised transactions?

It is the risk that exposure rises when the counterparty's credit quality falls. For collateral, it also arises when the posted asset is linked to the poster, such as its own debt or its parent's shares. The collateral then loses value when you need it.

Why do FX haircuts matter?

If collateral is in a different currency from the exposure, exchange rates can move during the margin period of risk. The FX haircut covers that loss. It is applied in addition to the price haircut.