A Model for Small Basket Equities Financing

Small basket equities financing is the bread and butter of hedge fund financing businesses. The collapse of Archegos Capital Management and the losses of its lending banks incurred in early 2021 are timely reminders of how challenging it is for banks to price and risk manage hedge fund transactions. This article develops an equity portfolio financing haircut model that gives credit analysts flexibility when assessing borrower credit quality given hedge funds’ operational opacity and lack of market traded credit products. Recent historical data are used to estimate the Black-Karasinski credit model and double-exponential jump-diffusion asset price model per stock. Computational results for a basket of four Archegos holding stocks show sensible haircuts and haircut diversification effect. A bank opting to trade at less favorable haircut levels could price in higher economic capital charge to compensate and use that to incentivize its funding unit.