Haircut (finance)

In finance, a haircut is the difference between the market value of an asset used as loan collateral and the amount of the loan.[1] The amount of the haircut reflects the lender's perceived risk of loss from the asset falling in value or being sold in a fire sale. The lender will, however, still hold a lien for the entire value of the asset. In the event the collateral is sold to repay the loan, the lender will have a higher chance of being made whole.

Expressed as a percentage of the collateral's market value, the haircut is the complement of the Loan-to-value ratio (together they equal 100% of the value.)

For example, United States Treasury bills, which are seen as fairly safe, might have a haircut of 10%, while for stock options, which are seen as highly risky, the haircut might be as high as 30%. In other words, a $1000 treasury bill will be accepted as collateral for a $900 loan, while a $1000 stock option might only allow a $700 loan.

Lower haircuts allow for more leverage. Haircut has an important role on many kinds of trades, for example for Repo or Reverse Repo.

In popular media, "haircut" has been used to denote a financial loss on an investment, as in "to take a haircut" (to accept or receive less than is owed.) Especially following the financial crisis of 2008, the term was popular in political debates surrounding the propriety of various government actions in response to the crisis.[2]

History

Haircuts have been used for almost 200 years in American commercial finance.

ECB use of haircuts

The European Central Bank applies a haircut to all securities offered as collateral. The size of the haircut depends on the riskiness and liquidity of the security offered as collateral.[3]

LTCM and haircut fees

The speculative hedge fund Long Term Capital Management (LTCM) saw spectacular losses and required massive bail outs in 1998. Prior to that it was able to obtain practically next-to-zero haircuts as its trades were considered safe by its lenders. This was likely due to LTCM's clout and the fact that no counterparty had a total picture of the extent of its complex and highly leveraged operations.[4]

As used for exchange-traded products

When used in the context of exchange traded products such as stocks, options, or futures, haircut is used interchangeably with the term margin. It is the amount of capital required by a broker to maintain the positions currently in a trading account. If haircut exceeds the account's capital, the broker can either require additional capital (e.g., margin call), or liquidate positions until the haircut no longer exceeds available capital.

References

  1. ↑ What Does Haircut Mean?
  2. ↑ NY Times Magazine, On Language: Haircut
  3. ↑ ECB Risk control framework
  4. ↑ Jorion, P. (1999), "Risk Management Lessons from Long-Term Capital Management"

External links