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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A clearing member's collateral portfolio is USD 200 million of a single corporate bond issue that trades thinly. Risk management wants to set the haircut using a 10-day liquidation horizon. Daily price volatility is 1.0%, and they use a 99% one-tailed normal multiplier of 2.33 with square-root-of-time scaling. If the liquidity add-on is ignored, what is the base haircut, and which statement about thin trading is correct?

The base haircut is about 7.4%, from 2.33 times 1% daily volatility times the square root of ten. Because the bond trades thinly, price impact and longer liquidation are not captured by volatility, so a higher haircut or longer horizon is warranted.

  1. AAbout 7.4%; thin trading justifies a higher haircut or longer horizon than the base figureCorrect
  2. BAbout 2.3%; thin trading justifies a lower haircut because volatility is low
  3. CAbout 23.3%; square-root scaling is not applicable to haircuts
  4. DAbout 7.4%; thin trading is irrelevant if volatility is measured correctly

Explanation

Base haircut = 2.33 x 1.0% x sqrt(10) = 2.33 x 3.162% = 7.37%, about 7.4%. 2.3% omits time scaling. 23.3% multiplies by 10 instead of sqrt(10). Thin trading means price impact and longer liquidation, so observed volatility understates liquidation risk and the haircut or horizon should be increased.

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