DEFINITION of 'Risk-Based Haircut'
A reduction in the recognized value of an asset in order to produce an estimate for the level of margin or financial leverage that is acceptable to use when purchasing or continuing to own the asset. An analyst undertaking a risk-based haircut of an asset attempts to determine the chances of the asset's value falling below its current level, so that a sufficient buffer can be established to protect against a margin call.
BREAKING DOWN 'Risk-Based Haircut'
A risk-based haircut is important to do in order to provide a margin of safety to protect against the possibility of a margin call or similar type of over-leveraged position in a security. By artificially reducing the recognized value of an asset before undertaking a leveraged position in it, the actual market value of the asset must fall by an increased amount than if no haircut was applied in order for a margin call to take place. This decreases the chances of an ill-time margin call or forced sale of the security for a low price taking place in the investors account.