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Haircut

The reduction in an asset's value to calculate the capital requirement, margin and collateral level

What is a Haircut (in finance)?

In finance, a haircut refers to the reduction applied to the value of an asset for the purpose of calculating the capital requirement, margin, and collateral level. In other words, it is the difference between the market value of an asset used as collateral and the amount of loan given against it. The value reduction is expressed in the form of a percentage.

A haircut can also be referred to as the complement of the loan-to-value ratio (when added together, they make 100%). For example, when central banks lend money to commercial banks, the central bank asks for collateral. However, it will apply a haircut – a reduction in the value of the collateral. Let’s say, an asset worth $1 million at market price, given a haircut of 30%, would be sufficient to collateralize a loan of only $700,000. By devaluing the assets provided as collateral, the lender gets a cushion, a measure of risk protection in case the market value falls.

 

Haircut theme in finance

 

The degree of haircut is determined by the amount of risk associated with the loan. These risks include all factors or variables that may lead to a fall in the market value of the collateral in the event that the lender needs to sell it due to the default by the borrower. Some variables that influence the amount of haircut include interest rate, creditworthiness, and liquidity risks.

 

Other definitions of a Haircut

A haircut can also be referred to as the difference between the buying and selling price of a stock share, bond, futures or options contract, or any other financial instrument. The difference is generally the handling fee for the transaction.

In common financial jargon, a haircut is also used to describe a financial loss on an investment. To “take a haircut” corresponds to accepting or receiving less than what was owed.

 

Variables affecting the amount of haircut

The lender needs to consider the amount of risk he would face in the event of not being able to sell the asset (collateral) for a sufficient amount of money in case of default by the borrower.

Price predictability and lesser associated risks will result in compressed haircuts, because of the high degree of certainty by the lender that the full amount of loan will be recovered if the collateral is liquidated. For example, Treasury bills are most commonly used as collateral for overnight borrowing arrangements between government securities dealers (repurchase agreements). In such cases, the haircut is negligible or very low due to the high level of certainty regarding the value, credit quality, and liquidity of the security, especially when the time frame is short.

On the other hand, securities marked by high volatility and price uncertainty often have steep haircuts applied when used as collateral. For example, an individual seeking to borrow funds by keeping equity positions to a margin account as collateral may have to face a 50% haircut due to lack of price predictability.

While a 50% reduction is used most commonly for margin accounts, it can be increased to an even higher level if the securities pose higher volatility and liquidity risks. For example, haircuts on leveraged exchange-traded funds that are highly volatile can rise as high as 90%.

The amount of haircut also depends on how liquid the collateral is. If the asset is highly liquid, then it will be easy to sell it quickly without any loss of value. Hence, a smaller reduction will be imposed. An asset which is much harder to sell for fair market value will carry a larger haircut. Government bonds are safe and liquid instruments. Hence, they carry a much smaller haircut as compared to other financial instruments.

 

Haircuts play an important role in facilitating many kinds of trades, such as repurchase agreements and reverse repurchase agreements.

 

Additional resources

  • Cost Behavior Analysis
  • Buying on Margin
  • Marginal Revenue
  • Expected Returns

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