A haircut is a percentage reduction applied to the market value of an asset when calculating the amount of collateral required for a loan or margin account.
Understanding haircuts in finance
Lenders require collateral to mitigate the risk of a borrower defaulting. Because asset prices fluctuate in the open market, lenders need protection against a potential drop in the value of the pledged collateral. They do not offer loans equal to the full market value of the asset. They apply a haircut to establish a lower recognized value for the transaction.
The size of the haircut depends on the risk profile of the underlying asset. Highly liquid and stable assets attract small haircuts. Volatile or illiquid assets face much larger haircuts. Financial institutions assess historical price volatility and secondary market liquidity when setting the haircut percentage. Government bonds from stable economies receive very low haircuts, while volatile equities receive high haircuts.
Haircuts are a standard mechanic in institutional repurchase agreements and retail margin trading. They provide a financial buffer. If a borrower defaults and the lender seizes the collateral, the haircut absorbs the loss in value that might occur while the lender sells the asset on the open market. Elephants trading on margin encounter haircuts when brokers calculate their buying power and maintenance requirements.
Example
An Elephant investor holds a portfolio of corporate bonds with a current market value of $100,000. The Elephant wants to borrow cash from a brokerage to buy more corporate bonds, using the existing corporate bonds as collateral.
The brokerage evaluates the corporate bonds and applies a 10% haircut due to the specific risk profile of the corporate bonds. The brokerage subtracts $10,000 from the market value, valuing the collateral at $90,000 for borrowing purposes. The Elephant receives a maximum loan of $90,000. If the corporate bonds drop in value and the Elephant fails to meet a margin call, the brokerage has a $10,000 cushion to sell the corporate bonds and recover the loaned cash.