In the financial
industry, a haircut is a value reduction made to an asset to determine
the capital required, margin, and level of collateral. The difference between a
loan’s principal and the asset’s market value will serve as collateral. This amount
is given as a percentage. The lender must consider the shifting market price
over time, which results in the disparity.
The
distinction between the purchase and sale price of a stock, bond, derivative
contract, or any other financial instrument is sometimes referred to as a
haircut. The phrase “haircut” refers to the market maker’s spread in
this context.
How to
Interpret a Haircut
When a financial
institution or lender assigns a value to a collateral asset less than
the requested loan amount, this is known as a haircut. The lender chooses the
haircut amount, which varies depending on the institution and situation and is
typically expressed as a percentage difference. The amount of haircut is
determined by weighing the hazards. For example, if the borrower defaults, the
lender must take into account the level of risk they would run if they could
not sell the asset or collateral for a high enough price.
Compressed
haircuts result from high price predictability and lesser associated risks
because the lender is confident that the collateral can satisfy the loan amount
upon liquidation. As an illustration, government securities dealers frequently
employ treasury bills in overnight borrowing transactions, also known as
repurchase agreements (repos). Due to the high level of assurance regarding the
value, liquidity, and credit rating of the securities used as collateral in
such instances, the haircut is minimal.
Example
For
instance, if a borrower seeks out a loan for $15000 from a financial
institution and uses their stock portfolio worth $15000 as security, the
financial institution will very likely recognize the $15000 portfolio as only
worth $7500 as collateral. The haircut is the value of the stock portfolio
provided as collateral reduced by 50%, or $7500.
There is no
one-size-fits-all percentage for haircuts because each asset must be handled
uniquely. For example, an asset may have a value of $10000, but if it receives
a 10% haircut, it will only be valued at $9000. In a similar light, another
item might be worth $10000 but given a haircut of 30%, meaning it is regarded
as though its value were $7000.
Important
Takeaways and Final Overview
· A haircut is
a difference between the price at which a stock is bought and sold, or the
spread market makers may establish.
· The
discrepancy between the loan amount and the market value of collateralized
assets is known as a haircut in the finance industry.
· The safer the
asset, the lower the haircut, and the riskier the asset, the greater the
haircut.
To sum this
up, Lenders take a haircut, or a percentage reduction in the value of the asset
used as collateral for the loan, to shield themselves from price volatility and
associated risks. When a borrower defaults on their obligations, financial
institutions calculate the value of the collateral asset and assign that value
to the asset.
Lenders must
evaluate the collateral as an independent case to assess the associated risks,
including volatility, price predictability, and liquidity. Different assets are
addressed in different ways.