Loading the player...

What is a 'Haircut'

A haircut is the difference between prices at which a market maker can buy and sell a security. The term comes from the fact that market makers can trade at such a thin spread. The term may also refer to the percentage by which an asset's market value is reduced for the purpose of calculating capital requirement, margin, and collateral levels.

BREAKING DOWN 'Haircut'

A haircut refers to a negative spread between either the buying and selling prices of a security, or the lower-than-market value placed on a security being used as collateral. The haircut is expressed as a percentage of the markdown between the two values. When they are used as collateral, securities are generally devalued, since a cushion is required by the lending parties in case the market value falls.

When collateral is being pledged, the degree of the haircut is determined by the amount of associated risk to the lender. These risks include any variables that may affect the value of the collateral in the event that the lender has to sell the security due to a default by the borrower. Variables that may influence that amount of a haircut include price, credit and liquidity risks of the collateral.

What Determines a Haircut?

Generally speaking, price predictability and lower associated risks result in compressed haircuts, as the lender has a high degree of certainty that the full amount of the loan can be covered if the collateral must be liquidated. For example, Treasury bills are often used as collateral for overnight borrowing arrangements between government securities dealers, which are referred to as repurchase agreements (repos). In these arrangements, haircuts are negligible due to the high degree of certainty on the value, credit quality, and liquidity of the security, especially over a short time frame.

Securities that are characterized by volatility and price uncertainty, on the other hand, have steep haircuts when used as collateral. For example, an investor seeking to borrow funds from a brokerage by posting equity positions to a margin account as collateral can only borrow 50% of the value of the account due to the lack of price predictability, which is a haircut of 50%.

While a 50% haircut is standard for margin accounts, a risk-based haircut can be increased if the deposited securities pose liquidity or volatility risks. For example, the haircut on a portfolio of leveraged exchange-traded funds (ETFs), which are highly volatile, may be as high as 90%. Penny stocks, which pose price, volatility, and liquidity risks, cannot be used as collateral in margin accounts.

RELATED TERMS
  1. Additional Collateral

    Additional assets put up as collateral by a borrower against ...
  2. Cross Collateralization

    The act of using an asset that is currently being used as collateral ...
  3. Collateral Value

    A collateral value is the estimated fair market value of an asset ...
  4. Borrowing Power Of Securities

    The value associated with being able to invest in securities ...
  5. Collateral Trust Bond

    A collateral trust bond is a bond that is secured by a financial ...
  6. Side Collateral

    A pledge that partially collateralizes a loan. The pledge can ...
Related Articles
  1. Investing

    Securities Lending: Cause Of The Next Financial Crisis?

    Securities lending can pose risks to investor's portfolios and the entire financial system.
  2. Personal Finance

    What Is A Mortgage?

    A mortgage is a loan used to purchase a home, where the property serves as the borrower's collateral.
  3. Tech

    Is SALT Blockchain-Based Lending the Future of All Personal Loans?

    Here, we explore SALT, blockchain backed lending, how to do it, and whether or not it's a good idea.
  4. Small Business

    Bailout Acronyms 101

    The subprime meltdown gave rise to a mouthful of financial acronyms. Learn how to sort through this alphabet soup.
  5. Trading

    Margin Trading

    Find out what margin is, how margin calls work, the advantages of leverage and why using margin can be risky.
  6. Financial Advisor

    Why Securities-Based Lending Became A Big Business

    Securities-based lending—using one's investments as collateral to secure a loan—has become big business for brokers and banks. Should we be concerned about its increasing popularity?
  7. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  8. Investing

    Leveraged Investment Showdown

    Margin loans, futures and ETF options can all mean better returns, but which one should you pick?
RELATED FAQS
  1. What is the haircut rate imposed by clearing corporations?

    A haircut rate is a measure that reduces the value of any collateral used in a loan to ensure that when the effects of volatility ... Read Answer >>
  2. Asset-Based Lending Vs. Asset Financing

    Is there an actual difference between asset-based lending and asset financing? Read Answer >>
  3. Repo agreements versus vs. reverse repo agreements

    Learn about repurchase agreements and reverse repurchase agreements, their risks and tax implications, and where the Federal ... Read Answer >>
Hot Definitions
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  3. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  4. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  5. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
Trading Center