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What is a ‘Haircut’
A haircut is the difference between prices at which a customer base maker can buy and sell a security. The term comes from the fact that customer base makers can trade at such a thin spread. The term may also refer to the portion by which an asset’s market value is reduced for the purpose of calculating splendid requirement, margin, and collateral levels.
BREAKING DOWN ‘Haircut’
A haircut refers to a neutralizing spread between either the buying and selling prices of a security, or the lower-than-market value placed on a surveillance being used as collateral. The haircut is expressed as a percentage of the markdown between the two values. When they are in use accustomed to as collateral, securities are generally devalued, since a cushion is required by the furnish parties in case the market value falls.
When collateral is being pledged, the station of the haircut is determined by the amount of associated risk to the lender. These dangers include any variables that may affect the value of the collateral in the event that the lender has to clerk the security due to a default by the borrower. Variables that may influence that amount of a haircut subsume price, credit and liquidity risks of the collateral.
What Determines a Haircut?
Non-specifically speaking, price predictability and lower associated risks result in compressed haircuts, as the lender has a acute degree of certainty that the full amount of the loan can be covered if the collateral be required to be liquidated. For example, Treasury bills are often used as collateral for overnight mooch arrangements between government securities dealers, which are referred to as repurchase bargains (repos). In these arrangements, haircuts are negligible due to the high degree of for sure on the value, credit quality and liquidity of the security, especially over a straight time frame.
Securities that are characterized by volatility and price uncertainty, on the other round, have steep haircuts when used as collateral. For example, an investor quest after to borrow funds from a brokerage by posting equity positions to a side account as collateral can only borrow 50% of the value of the account due to the require of price predictability, which is a haircut of 50%.
While a 50% haircut is definitive for margin accounts, a risk-based haircut can be increased if the deposited securities set liquidity or volatility risks. For example, the haircut on a portfolio of leveraged exchange-traded breads (ETFs), which are highly volatile, may be as high as 90%. Penny deal ins, which pose price, volatility and liquidity risks, cannot be acclimated to as collateral in margin accounts.