Haircut
Candlefocus EditorThe size of a haircut is largely determined by the risk of the underlying asset. Generally, riskier assets receive larger haircuts, as lenders need to have sufficient cover should the value of the asset decline. The lender will typically determine the haircut, though it will depend on the specific contract conditions and legal terms.
Haircut and margin are terms that are often used interchangeably, though they refer to the same concept. Essentially, they both refer to the practice of reducing an asset's value to reduce risk. Margin is usually used in the derivatives market, and refers to the practice of ensuring a borrower has sufficient collateral for cash loans.
One example of a haircut is when an investor wants to purchase a share of stock that is being held by a bank. The bank may put a haircut on the security, meaning the investor will not be able to buy it for its market value, but for slightly less. Similarly, this concept may be used in the forex market, where a central bank may require its members to put a loan’s assets up as collateral with some type of haircut applied.
In the equities market, market makers may refer to “haircut-like” spreads. This refers to the opportunity to make money by taking advantage of disparities in bid and offer prices of similar securities. This is possible due to the fact that the spread between two securities will often be wider than the spread between two identical securities.
Haircuts are an important risk management tool and can be used by a lender to protect itself in the event of a borrower not being able to repay their loan. At the same time, it is highly important for borrowers to understand the potential impact of a haircut on a loan before they enter into it, so that they can ensure they receive the full market value of their assets.