Collateral Valuation

Collateral valuation is the process of working out how much protection a pool of collateral provides. The collateral taker starts from the current market price of each asset and reduces it by a percentage, the haircut, to allow for the possibility that the price will fall before the asset can be sold. The result is compared with the exposure being secured to decide whether more collateral must be called or some returned.

Valuation follows on from collateral eligibility, which determines whether an asset may be used at all. In financial markets, where collateral consists of cash and securities, values are updated at least daily. A different approach applies to physical assets pledged against loans, such as property and equipment, which are appraised periodically; this is covered under collateral valuation for lending.

The standard calculation for a security is:

• Market value is the price of the security multiplied by the quantity held, including accrued interest for bonds, converted into the currency of the exposure.
• Haircut is the percentage deduction set by agreement, rule or regulation.

Suppose a firm posts government bonds with a market value of 10,000,000 euros against a dollar exposure, and the agreement applies a haircut of 2% for the bonds and a further 8% because the collateral currency differs from the exposure currency. The total haircut is 10%, so the collateral is credited at 10,000,000 multiplied by 0.90, the equivalent of 9,000,000 euros. To cover an exposure equivalent to 9,000,000, the firm must therefore deliver bonds worth 10,000,000.

Some agreements express the same thing as a valuation percentage, here 90%.

The price used is the current one, a practice known as mark-to-market. For actively traded government bonds and listed shares, closing or intraday prices are taken from exchanges and data vendors. For bonds, the valuation uses the clean price plus bond accrued interest. For less liquid securities, prices may come from dealer quotations or from evaluated pricing services that estimate value from comparable instruments. Positions in a foreign currency are converted at the day's exchange rate.

The agreement names a valuation agent and the time and sources to be used. Where the two parties' figures differ beyond a tolerance, the matter is handled as a collateral dispute. In tri-party collateral management, the agent values all collateral on a common basis, which removes one source of disagreement.

The collateral haircut is intended to cover the likely fall in value over the time it would take to realise the asset after a default. The main factors are:

• Price volatility. More volatile assets, such as equities and long-dated bonds, carry larger haircuts than short-dated government bonds.
• Credit quality. Lower-rated issuers attract higher haircuts.
• Liquidity. Assets that may be hard to sell in size are discounted further.
• Currency mismatch. An extra haircut applies when collateral and exposure are in different currencies.
• Liquidation period. A longer assumed time to sell increases the haircut.
• Correlation with the counterparty. Assets whose value would fall if the provider defaulted are penalised or excluded.

Cash in the same currency as the exposure usually has no haircut. Haircuts may be negotiated between the parties, published by a central counterparty (CCP) or a central bank, or prescribed by regulation. The margin rules for uncleared derivatives offer a standard schedule, ranging from small percentages for short-dated high-quality government bonds to 15% for main-index equities and gold, with 8% added for currency mismatch; firms may instead use approved internal models. Bank capital rules contain supervisory haircuts for recognising collateral as credit risk mitigation.

For derivatives and repurchase agreements, both the exposure and the collateral are revalued each business day, and more often by clearing houses in volatile markets. If the adjusted collateral value falls short of the exposure by more than the agreed minimum, a margin call is made; if it exceeds it, the surplus can be recalled. Payments reflecting changes in the value of the secured portfolio are variation margin.

Valuation is only as good as the prices and haircuts behind it. In stressed markets, quoted prices may not be achievable for large amounts, and securities that seemed liquid can become difficult to sell; this is the liquidity risk in collateral. Models calibrated on calm periods can produce haircuts that prove too small.

Haircuts also tend to be procyclical. When volatility rises, lenders and clearing houses raise them, so the same assets support less borrowing just as borrowers are under pressure. This can force sales, which push prices down further. The pattern was evident in repo markets in 2008 and again in episodes since. International standard setters have responded with minimum haircut floors for certain securities financing transactions and with guidance asking clearing houses to limit abrupt changes.

Daily checks on price sources and reconciliation with counterparties are standard controls within collateral management. Accounting standards separately classify prices by how observable they are, a ranking described under the IFRS fair value hierarchy.