Definition
In finance parlance, a haircut refers to the reduction of an asset’s market value when pledged as collateral against loans. More risky securities generally receive larger haircuts.
Characteristics
Haircut is one of many terms used to refer to collateral that lenders value at less than its total amount, similar to margin. Both concepts can often be used interchangeably.
Meaning
The term haircut refers to the lower-than-market value placed on an asset when used as collateral for loans, typically depending on its risk and volatility. Less volatile investments typically receive more negligible haircuts. The purpose of the haircut is to provide lending parties with some cushion in case the collateral’s market value declines over time, thus protecting against liquidation losses and themselves from further losses when liquidating an asset.
Call Haircuts and Margin
Call haircuts are similar to margin because both aim to arbitrarily reduce an asset’s value for risk mitigation. However, a haircut usually refers to a reduction in weight, while a margin is generally expressed as either a percentage of its initial purchase price or as a ratio.
Repo Transactions and Initial Margins
Repo transactions use haircuts and initial margins to mitigate the risk of loss to non-defaulting parties if they must liquidate collateral. Higher price volatility and liquidity risks often necessitate larger haircuts; lower prices with predictable characteristics typically warrant smaller ones. A higher initial margin may also be required if collateral is deposited in different currencies, as this increases its exposure to potential market price differences that could mean purchasing securities at higher costs in local markets.
Using Haircuts in Market-Making
The haircut is also used for market maker spreads that offer razor-thin spreads that take away some profit when assets are traded by market makers, sometimes seen in action films when characters come close to being hit with bullets or blades, with loose strands of hair flying about as evidence of that threat.
