Lesson 21 of 25 · 7 min
A risk that is priced, and a risk that is not
Somebody quantified the haircut and charged for it; nobody quantified the right to change it, and that one is free.
A priced risk is one that somebody measured, attached a number to, and collected for. An unpriced risk is carried without any number appearing anywhere. The distinction is not about which is larger. It is about which one you can find.
The haircut is the priced one. On $1,480,000 of collateral at a 30 percent haircut, the lender withholds $444,000 of market value. That withholding is a quantified estimate of how far the asset can move during a liquidation window — a value-at-risk statement in the sense of lesson 9 — and it is paid for in foregone capacity and in the spread on what is drawn. It appears on the page as an advance rate. Someone did the work and billed for it.
The right to revise the haircut is the unpriced one. The agreement grants it, and nothing in the cost of the facility changes when it is exercised. There is no premium line, no fee, and no disclosure of what the right is worth to the party holding it.
It can still be valued from the borrower's side. Capacity at a 30 percent haircut with an 80 percent threshold is $1,480,000 × 0.70 × 0.80 = $828,800. At a 38 percent haircut it is $1,480,000 × 0.62 × 0.80 = $734,080. So the right to move the haircut eight points is the right to withdraw $94,720 of capacity, 11.43 percent of the total, at a moment of the holder's choosing. A borrower wanting immunity would have to operate permanently at the lower figure; carrying $94,720 undrawn at an illustrative 6.4 percent borrowing rate against a 4.1 percent cash yield costs $2,178.56 a year.
One risk has a number, a method and an invoice. The other has a clause. The gap is not one of severity — it is whether anyone was ever required to state what it was worth.
Key terms
- Priced risk
- An exposure someone quantified and charged for, so that a figure for it exists somewhere. A haircut is the clearest example in a pledged facility.
- Unpriced risk
- An exposure borne without any corresponding number or charge. It is invisible on a statement, which is different from being small.
- Discretionary right
- A permission one party may exercise without the other's agreement. Valuable to the holder and costless to hold, since nothing in the pricing reflects it.
Worked example
Valuing the right that has no price
Collateral $1,480,000, haircut 30 percent, threshold 80 percent of lending value. Illustrative rates of 6.4 percent borrowing and 4.1 percent cash.
- Market value withheld by the haircut
- $444,000
- Capacity at a 30 percent haircut
- $828,800
- Capacity at a 38 percent haircut
- $734,080
- Capacity the revision removes
- $94,720
- Annual cost of self-insuring against it
- $2,178.56
- Charge appearing for the right itself
- None
The priced piece. $1,480,000 × 0.30.
$1,480,000 × 0.70 × 0.80.
$1,480,000 × 0.62 × 0.80.
11.43 percent of the total.
$94,720 × (6.4% − 4.1%).
The unpriced item has a computable annual cost of $2,178.56 and no line on any document. The priced item has $444,000 and an advance rate.
Check yourself
A haircut of 30 percent withholds $444,000 of a $1,480,000 portfolio, and the agreement permits revision to 38 percent. Which of these two risks is priced, and what is the other one worth?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.