Haircut in Finance – Definition and Example

What is a Haircut in Finance?

The term haircut in finance refers to the reduction applied to an asset’s value for the purpose of calculating the capital requirement, margin, and level of collateral. It is the difference between the amount of a loan and the market value of the asset to be used as collateral for the loan. This value is expressed in percentage form. The difference arises because the lender has to account for the changes in market price over time.

A haircut can also be used to refer to the difference between the buying and selling price of a stock, bond or derivative contract, or any other financial instrument. In this sense, the term haircut is used to express the market maker’s spread.

Understanding a Haircut

A haircut occurs when a financial institution or lender places a value on a collateral asset that is lower than the requested loan amount. The lender determines the haircut amount which is usually expressed as a percentage difference and it varies by institution and scenario. The haircut amount is arrived at by evaluating the risks involved. The lender must consider the amount of risk they would face if they are unable to sell the asset or collateral for a sufficient amount of money in case of default by the borrower.

A high level of price predictability and lower related risks result in compressed haircuts, as the lender has a high degree of certainty that when liquidated, the collateral can cover the loan amount. As an example, Treasure bills are commonly used by government securities dealers when engaging in overnight borrowing deals also referred to as repurchase agreements (repos). In such scenarios, the haircut is negligible due to the high level of certainty regarding the value, liquidity, and credit rating of the securities used as collateral.

If after examination, a lender determines that there are high risks involved in loaning to a borrower, they might increase the haircut amount compared to a lower-risk asset or loan. Highly volatile securities as well as those that experience price uncertainty will carry larger haircuts. When a lender devalues an asset, they are increasing their protection in view of a drop in the market value. If it is evaluated that a borrower might default and the lender would have to sell the asset, they calculate how much the asset would reasonably sell for and assign that value to the asset.

Example

For instance, if a borrower seeks out a loan for $15000 from a financial institution and uses their stock portfolio worth $15000 as collateral, the financial institution will very likely recognize the $15000 portfolio as only worth $7500 in collateral. This 50% or $7500 reduction in the stock portfolio’s value used as collateral is referred to as the haircut.

Since every asset is to be treated differently, haircuts do not have a one-size-fits-all percentage. An asset might be worth $10000 but assigned a 10% haircut, implying it is treated as though it is worth $9000. In a similar light, another asset might be worth $10000 but given a haircut of 30%, meaning it is treated as though its value were $7000.

Haircut and Investors

The term haircut is also sometimes used in investing. For instance, if an investor requires a loan from a brokerage firm and presents equity positions to a margin account as collateral, they can borrow only 50% of the value of the account due to the lack of price predictability. Margin accounts have a standard haircut of 50%. However, this amount can be increased in case the deposited securities carry liquidity or volatility risks.

When an investor borrows a margin loan, the broker puts a value on the securities used as collateral. This provides the brokerage firm larger protection in case the market price of the securities decreases. The larger the haircut, the lower the value of the securities put up as collateral.

A haircut can be used to refer to a financial loss on an investment. That is a reduction in the value of an asset. Suppose an investor owns a zero-coupon bond with a face value of $1000 and for some reason, the issuer agrees later to repay only $400. This implies the investor will take a $600 haircut. To “take a haircut” refers to receiving less than what was owed.

Haircut and Market Maker Spreads

A haircut can also refer to the market maker’s spread. Due to the fact that market makers can trade with low transaction costs and very thin spreads, they can realize haircuts of profits or losses regularly during the day. The term haircut is used because the market maker’s spreads are so thin. The haircut depends on the fees and charges associated with the transaction, which are often in relation to the market makers.

Technological advancement and more efficient markets have caused a decrease in several assets spreads to haircut levels. It is more expensive for retail traders to transact at the same spreads as market makers. This renders transactions with spreads at haircut levels for retail traders unprofitable.

A haircut here refers to the difference between the buying and selling price of an asset or financial instrument. If a trader were to purchase 100 shares of ABC Incorporated for $100 per share, summing up to a total cost of $10000, then sell them a moment later. They might succeed in receiving only $90 per share adding up to a total of $9000 because of market makers. The 10% difference in price is the haircut, which is the fee market makers charge to offset risk. Day traders may experience this phenomenon as market makers help provide liquidity in the market.

Conclusion

In order to protect themselves from price unpredictability and related risks, lenders apply a percentage reduction to the value of the asset used as collateral for the loan called a haircut. Financial institutions calculate the price at which a collateral asset can be sold in case the borrower defaults on their obligations and assign that value to the asset. Different assets are treated differently so lenders must consider the collateral as an isolated case to evaluate the risks involved such as volatility, price predictability, and liquidity.

Investors seeking to access loans from brokerage firms to increase their portfolio holdings also face haircuts. Brokers charge a percentage reduction on the equity positions in margin accounts used as collateral to protect themselves from a decrease in the price of the securities.

Market makers and retail traders face a haircut in the form of the difference between the buying and selling price of an asset or financial instrument. Market makers can profit from such spreads since they typically have lower transaction costs compared to retail traders. Market makers through haircuts provide the markets with liquidity.

Below is a multiple-choice question to test your knowledge, download the Excel exercise sheet attached to find a full explanation of the correct answer.