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Haircut (finance)

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Haircut (finance)

In finance, a haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral.[1] The size of the haircut reflects the perceived risk associated with holding the asset. However, the lender has a lien for the entirety of the asset. The lower the haircut, the safer the loan is for a lender. The haircut and the LTV add up to 100%.

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.

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.[2]

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.[3]

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. ^ ECB Risk control framework
  3. ^ Jorion, P. (1999), "Risk Management Lessons from Long-Term Capital Management"

External links

  • Collateral Management article on Financial-edu.com
  • Haircut on Investopedia
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